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Appropriating profits (or losses) - the similarities and differences

The concept of a partnership has been around for many years – by definition, a partnership is formed when two or more persons work together in common, to make a profit (or loss as the case might be) i.e. there must be at least two persons, they must work together in common and the aim is to make a profit. If any of these three components are absent, then the business is not a partnership.

Any form of entity (such as a limited company) could be a partner in a partnership although for ICB purposes in its core assessments to become a Certified Bookkeeper, we treat each partner as an individual rather than an incorporated entity.

Partnerships have been around and in operation since Roman times but in the UK, the term partnership, as we understand it today, was first outlined in law by the Partnership Act of 1890 and although there have been updates since, the basic premise is still covered by this act, which contains the definition above.

This article covers the basics of partnership accounting, looks at the similarities between, and the differences from, sole trader accounts and then looks at the development of Limited Liability Partnerships (LLPs) which are becoming an increasingly popular way of running a business. It covers only what an ICB Certified Bookkeeper could be expected to know and understand, on a day-to-day basis, entering transactions and any required adjustments, without taking the theory through to the preparation of final accounts for taxation purposes and submission to the relevant authorities. It does not cover the standards that govern the preparation of such final accounts (for an LLP) as that is a topic for the Level 4 Diploma candidate.

The Partnership Agreement

Each partnership should have a legally binding partnership agreement drawn up. At the start of every partnership, those involved will probably be completely in agreement about how this will all work. However, as time goes on, and if disagreements arise, it is the partnership agreement that can determine the outcome of any disputes.

The agreement can stipulate (for example), how much capital will be invested by each partner and if interest will be paid on the individual’s investment, the amount of drawings that can be taken at any point in the financial year and if interest should be charged on any such drawings taken out, whether any partner can take a partnership salary (which does not fall under the PAYE scheme) and how profits and losses should be split.

If no agreement is in place, then, for a ‘simple’ partnership (not an LLP) in the event of a disagreement, the Partnership Act of 1890 stipulates how the partnership should be run with regards to the splitting of profits and losses (amongst other areas).

How does the financing work?

In a sole trader situation, the single business owner invests capital into the business. The profit and loss account contains a record of all income and expenditure and there is a balance sheet showing what is owned less what is owed (Net Assets) in the top half and how the capital value of the business has changed over the trading period in the bottom half. In essence the bottom half of the balance sheet shows how the opening capital is increased by the build-up of profits (or reduced in the case of losses) and reduced by the withdrawal of those profits to cover personal financial requirements (drawings).  Profits or losses are then transferred to the capital account and any drawings taken out. Hence the bottom half of the balance sheet shows:

Opening Capital + Net Profit (or less Net Loss) - Drawings = Closing Capital

This balance sheet section will mirror the entries in the capital account of the owner.

If the opening capital account had a credit balance of £70,000, the business made a net profit of £3000,000 and the owner withdrew £310,000 then the bottom half of the balance sheet would show:

               

£

Opening capital

70,000

Plus share of profit

300,000

Less drawings

310,000

Closing capital

60,000

 

The single business owner has sole rights to the profits of the business but carries unlimited liability for the debts of the business. The sole trader reports the profits by means of a self-assessment return to HMRC once a year and pays tax (and Class 2 and Class 4 NICs) accordingly.

A partnership works in a very similar way - two or more individuals invest their capital amounts, the business trades and produces a (trading and) profit and loss account and balance sheet and the partners take an agreed share of any profit (or loss). They too have unlimited liability to cover any debts incurred. The partnership reports under self-assessment to HMRC and notifies HMRC of the amount of profit taken by each partner. No tax or NICs are paid by the partnership and each partner must declare their share of the profits and pay their share of any relevant tax and NICs via their own self-assessment. Depending on their individual personal circumstances (they may have other sources of taxable income in addition to their profit share), each partner might take the same share of profits from the business but pay a different rate or amount of tax on those profits.

Bookkeeping entries

The bookkeeping entries for a partnership, up to the point of calculating the net profit or loss, is identical to that of the sole trader – income and business expenses are recorded, and any drawings taken out by an individual partner is recorded in their own drawings account. Any adjustments (depreciation, prepayment, accruals etc) are treated in the same way as for a sole trader. This amount of the net profit (or loss) is derived and it is at this point that the format of the accounts change as the partnership decides how this should be split. The profits or losses are appropriated to each partner.

The Partnership Appropriation Account

In its simplest form the net profit is split in the agreed share. If X, Y and Z are in partnership sharing profits and losses equally and the net profit for the year is £300,000 then each partner will take £100,000 as his or her share.

In a ‘manual’ bookkeeping system, a Partnership Appropriation Account is formed which is a continuation of the profit and loss account and starts with the brought down net profit (or loss) amount.

In the situation above, the appropriation account will be set out as follows:

Net profit b/f                                                     £300,000

Share of profits:

X                                             £100,000

Y                                              £100,000

Z                                              £100,000

                                                                      £300,000

 

In a trial balance, any net profit held in the profit and loss account has a credit balance and hence when the share of profit is posted to the accounts these entries will debit the profit and loss account. The double entry to this is to credit the capital account of each partner with the amount of their profit share.

If, at the start of the year the partners had the following balances on their respective capital accounts:  X : Y : Z = £15,000 : £25,000 : £30,000 then the bottom half of the balance sheet would be set out as:

               

X

£

Y

£

Z

£

Total

£

Opening capital

15,000

25,000

30,000

70,000

Plus share of profit

100,000

100,000

100,000

300,000

Closing capital

115,000

125,000

130,000

370,000

 

This replicates the entries in the capital account of each partner.

Note: in this example, and to show the similarities to the sole trader account, we are using the capital accounts to record all end of year profit transfers. In a partnership situation it is also possible to have fixed capital accounts and fluctuating partnership current accounts which show the year-to-year earnings and withdrawals. The end result of both methods will be the same and we will show the entries for this method further down.

Suppose however that the profits are not shared equally. If the profit split is agreed as X:Y:Z = 3:2:1 then the net profit is divided into six equal parts and each part is worth £50,000.  X takes 3 parts, Y takes 2 parts and Z takes the final part. The Appropriation Account will appear as:

Net profit                                                            £300,000

Share of profits:

X                                             £150,000

Y                                             £100,000

Z                                              £50,000

                                                                        £300,000

 

And the bottom half of the balance sheet will show the following:

               

X

£

Y

£

Z

£

Total

£

Opening capital

15,000

25,000

30,000

70,000

Plus share of profit

150,000

100,000

50,000

300,000

Closing capital

165,000

125,000

80,000

370,000

 

If each partner took the following drawings for the year

X : Y : Z = £140,000 : £110,000 : £60,000

the drawings balance would be transferred from the relevant drawings account to the relevant capital account and the bottom half of the balance sheet would appear as:

               

X

£

Y

£

Z

£

Total

£

Opening capital

15,000

25,000

30,000

70,000

Plus share of profit

150,000

100,000

50,000

300,000

Less drawings

(140,000)

(110,000)

(60,000)

(310,000)

Closing capital

25,000

15,000

20,000

60,000

 

So far this is almost identical to the entries for a sole trader, the only difference being that the transfers are made to multiple capital accounts rather than to a single account. As our opening balances, net profit and drawings figures are identical, then the final column of this balance sheet replicates that shown above for our sole trader.

However, let us suppose that one partner X works full time for the business whilst the others work only part time then it would be fairer to allow each partner an amount of profit to cover the time spent working on the business before splitting the remaining profits. This is called allowing each partner to take a partnership salary.

Because our partners are self-employed for tax purposes, the same rules follow as for those of a sole trader - the partners cannot be employed by the business and the salary is not paid under normal employee PAYE regulations. Hence such salaries do not form a part of the business expenses. The partnership salary is considered to be an appropriation of profits and as such as paid from the profits before the remaining balance is divided as per the profit share agreement. It is the introduction of partnership salaries that changes way that profits are transferred for a partnership from that carried out for the sole trader.

Let us assume that the salaries paid to the partners are as follows:

X : Y : Z = £60,000 : £30,000 : £30,000

Each partner would be allowed this amount of profits as a salary, leaving £180,000 to be split in the agreed partnership share. X would receive £90,000; Y would receive £60,000 and Z would receive £30,000

The Appropriation Account now becomes:

Net profit                                                            £300,000

Less partnership salaries:

X                                             £60,000

Y                                              £30,000

Z                                              £30,000

                                                                        £120,000

                                                                        £180,000

Share of profits:

X                                             £90,000

Y                                              £60,000

Z                                              £30,000

                                                                     £180,000

 

The balance sheet (and individual capital accounts) would now show:

               

X

£

Y

£

Z

£

Total

£

Opening capital

15,000

25,000

30,000

70,000

Plus Partnership salary

60,000

30,000

30,000

120,000

Plus Share of profit

90,000

60,000

30,000

180,000

Less Drawings taken

(140,000)

(110,000)

(60,000)

(310,000)

Closing capital

25,000

5,000

30,000

60,000

 

There are further calculations that can be carried out regarding paying interest on the capital and charging interest on drawings taken but we are not going into this much detail for this article.

At this stage it is vital to understand that the amount of profits finally allotted to each partner includes any partnership salary and not just the final split of any remaining profits as agreed in the profit share agreement.

So the final amounts that each partner ‘earns’ from the partnership will be:

X : Y : Z = £150,000 : £90,000 : £60,000

Note: in ICB assessments, marks are often lost in this area as some candidates omit to add in the amount of salary when asked to calculate the total figure (or share of profits) that each takes from the partnership.

Before moving on, we really should consider what happens in the event of a loss. Ignoring the effect of any drawings for now, if everything else remains the same, but the partnership makes a £60,000 loss (rather than the £300,000 profit as before), then the appropriation account would become:

Net loss                                                                (£60,000)

Less partnership salaries:

X                                             £60,000

Y                                             £30,000

Z                                             £30,000

                                                                       (£120,000)

                                                                       (£180,000)

Share of loss:

X                                             (£90,000)

Y                                             (£60,000)

Z                                             (£30,000

                                                                     (£180,000)

 

The balance sheet now becomes:

               

X

£

Y

£

Z

£

Total

£

Opening capital

15,000

25,000

30,000

70,000

Plus Partnership salary

60,000

30,000

30,000

120,000

Less Share of loss

(90,000)

(60,000)

(30,000)

(180,000)

Closing capital

(15,000)

(5,000)

30,000

(10,000)

 

This situation is rapidly becoming un-viable. The actual capital accounts are already overdrawn, before any drawings are taken into consideration. If the drawings remain the same as before then this partnership is rapidly heading into massive failure.

               

X

£

Y

£

Z

£

Total

£

Opening capital

15,000

25,000

30,000

70,000

Plus Partnership salary

60,000

30,000

30,000

120,000

Less Share of loss

(90,000)

(60,000)

(30,000)

(180,000)

Less drawings

(140,000)

(110,000)

(60,000)

(310,000)

Closing capital

(155,000)

(115,000)

(30,000)

(300,000)

 

Computerised accounting journal entries

Returning to our profit-making situation, when entering these appropriations into a computerised system, there is no appropriation account as such (although on could be set up in the chart of accounts and used). In its simplest format, the transfers would be carried by means of a journal entry to clear down the £300,000 net profit balance and post directly to the relevant capital account.

 

Account

Details

Dr

Cr

X Capital Account

Partnership salary

 

£60,000

Y Capital Account

Partnership salary

 

£30,000

Z Capital Account

Partnership salary

 

£30,000

Profit and Loss Account

Partnership salaries

£120,000

 

X Capital Account

Share of profit

 

£90,000

Y Capital Account

Share of profit

 

£60,000

Z Capital Account

Share of profit

 

£30,000

Profit and Loss Account

Profit share

£180,000

 

 

In addition, the drawings balances would also be transferred to the relevant capital accounts which will lead to the balances shown on the balance sheet.

Earlier on we mentioned the introduction of the partners’ current accounts. In this way the capital account is left unchanged and all annual profit share and drawings are shown in a separate account.

Splitting these out amends the balance sheet to:

               

X

£

Y

£

Z

£

Total

£

Capital accounts

15,000

25,000

30,000

70,000

Current Accounts

 

 

 

 

Opening current account balances

0

0

0

0

Plus Partnership salary

60,000

30,000

30,000

120,000

Plus Share of profit

90,000

60,000

30,000

180,000

Less Drawings taken

(140,000)

(110,000)

(60,000)

(310,000)

Closing Current Account balances

10,000

(20,000)

0,000

(10,000)

 

The final result is that the overall investment is £60,000 after all transactions have been posted. Note that Y has a negative balance on their current account (which will show as a debit balance). This means that Y has drawn out more than he or she has earned in the year and could be seen to ‘owe’ the partnership £20,000. The partnership would need to agree that this can continue, with the debit balance being carried forward to the next year or ask Y to re-imburse the funds that have been overdrawn.

Limited Liability Partnerships

As explained above, the traditional definition of a partnership is “the relationship which subsists between two or more persons carrying on a business in common with a view of profit”.

However, problems arose out of the nature of traditional partnerships for larger professional practices, such as accountants and solicitors. Partners were becoming increasingly concerned that in a large practice, each was considered responsible for the debts and behaviour of all partners with no right of oversight of the behaviour of other partners. The result was the introduction of a new type of legal entity i.e. The Limited Liability Partnership (LLP).

The format of a limited liability partnership (LLP) was introduced in 2000 in Great Britain. LLPs are governed by the Limited Liability Partnerships Act 2000 which came into force on 6 April 2001.

LLPs exhibit elements of both partnerships and corporations such as:

  • There must be a minimum of two partners (or members as they are officially termed) to form an LLP and a member may be an individual or a corporate entity, although the corporate entity can be a dormant company
  • The partnership must have a registered address (known as principal place of business) to which official communications can be sent (for example letters from HMRC and Companies House)
  • The partnership must be registered at Companies House and will receive a Certificate of Incorporation
  • The partnership should have an agreement similar to that of a traditional partnership that details such areas as introduction of members’ capital and the sharing of profits/losses of the partnership for accounting periods

Members can be ‘designated members’ (as recognised in the Companies Act) or ‘ordinary members’ but here must be at least two designated members to form the LLP. Both types of members have similar rights, but designated members have additional responsibilities in law.

Note: to compound the issue, there is a further type of partnership called a Limited Partnership where Partners can be ‘limited partners’ or ‘general partners’. The main difference is that to retain the limited liability the partner cannot take part in the management of the partnership. If they do take on any management responsibility, they become a general partner and their responsibility for the debts of the business becomes unlimited as in a simple partnership.

For the purposes of the rest of this article (and for ICB assessments), unless specially mentioned otherwise, we will assume that all such partnerships are Limited Liability Partnerships and hence all members have limited liability.

As the LLP is an incorporated entity, its final accounts must be produced under the same rules as govern that of any incorporated entity i.e. they must report under either International reporting Standards, or UK General Accepted Accounting Practices (UKGAAP) which means looking at the requirements under either FRS102 or FRS105. Individual partners will also have to declare any income from the partnership via their self-assessment tax returns.

The Capital Accounts of LLP members

Each member of the LLP invests an amount of capital (in a similar way to a simple partnership). Although the partnership is incorporated, there is no share capital in LLPs (as with a limited company) and hence there is no need to transfer or issue more shares to bring in new LLP members. The appointment of new members simply requires an agreement with existing members. Anyone wishing to invest capital in an LLP must be an appointed a member who participates in the running of the business. LLPs may only accept loan capital from non-members.

Because the partnership has limited liability, and because the liability of each partner is limited to their capital investment, partners may not permanently withdraw or reduce their capital investment unless they leave, or the partnership goes into liquidation (when special rules apply). Partners may borrow from the partnership against their capital investment and can receive tax allowances against any interest paid to the partnership on that loan.

Note however that there are also circumstances where the investment can be treated, not as a capital investment, but as a liability that must be repaid under certain circumstances. This section of LLP theory falls outside the content of this article. For ICB purposes, any assessment up to and including the final assessment to become a Certified Bookkeeper, will treat all investment by members as capital investment, held in the relevant capital account. Further knowledge may be required for any Level 4 Diploma modules.

Partnership salaries

Probably one of the main differences between a partnership and a limited liability partnership (as far as keeping the books of the LLP are concerned) is the treatment of partnership salaries. Many LLPs are formed by accountancy or legal practices and as such we meet the concept of the ‘senior’ partner versus the ‘junior’ partner. Senior partners will receive their income mainly as an appropriation of profits and any salary allowed to a senior partner is likely to still be treated as an appropriation of profits. Senior partners are considered to be self-employed and will declare all income via their personal self-assessment return. No PAYE or NICs are involved for the partnership on their profit appropriation.

A junior partner’s treatment can be very different. They will still be expected to invest a capital amount into the LLP on acceptance as a partner but their rights as a partner can be very different.

Since 2014, depending on the agreement as to the way a junior partner is paid, any salary may now need to be treated as an employee salary and subject to PAYE and NICs as any other employee, whilst their share of any profits will be treated as an appropriation of profit in the normal way.

How does an LLP decide which is the relevant treatment? There are three rules that govern this and all three must be considered:

  1. Consider if at least 80% of the total amount payable by the LLP for the member's services to the LLP (in his or her capacity as a member of the LLP) is fixed and determined, or is variable but not with respect to the profits made by the partnership in which case the salary is called a ‘disguised’ salary
  2. Decide whether the member has or does not have a significant influence over the affairs of the LLP – the important one here is if the partner does not have a significant influence
  3. Calculate whether a member's capital contribution to the LLP is less than 25% of the Disguised Salary expected to be payable by the LLP to that member in the relevant tax year.

If all the above three conditions are fulfilled, (i.e. salary is at least 80% of the amount paid, the partner does not have significant influence and their capital contribution is less than 25% of the salary paid) then the salary portion of the income paid to the partner must be treated as income from employment, subject to the normal rules of PAYE and NICs and is treated as a business expense in the profit and loss account and not as an appropriation of the profits of the partnership. If any one of the above is not satisfied, then the partner’s entire income is treated as an appropriation of profits.

The Appropriation Account

Let us have a look at our example of X,Y and Z again, but this time in the light of a limited liability partnership. The original capital contribution remains the same, as do the salaries paid and the appropriation of profits. All three have a significant influence on the running of the business. Their capital investment remains unchanged at X:Y:Z = £15,000 : £25,000 : £30,000

The appropriation of profits remains unchanged

Net profit                                                            £300,000

Less partnership salaries:

X                                             £60,000

Y                                              £30,000

Z                                              £30,000

                                                                     £120,000

                                                                     £180,000

Share of profits:

X                                             £90,000

Y                                             £60,000

Z                                             £30,000

                                                                     £180,000

But we must now look at each condition in turn:

1                     None of the salaries is 80% or more of their total earnings

2                     All three have significant influence on the business

3                     The capital contribution of all three is at least 25% of their salaries

Hence the test fails on all three points – all three partners are senior partners and none of the salaries can be considered as an employment salary.

Now look at the following scenario – their capital contributions are very different – X has a reduced investment, but Y and Z have vastly increased contributions made when the business was set up. X no longer has a significant influence over the decision-making process

Capital introduced = X : Y : Z = £10,000 : £100,000 : £100,000 and the profit-sharing ratio is 2:4:4

Now assume that the partnership salary payments are as follows:

X                                             £60,000

Y                                              £50,000

Z                                              £60,000                 £170,000

The remaining profits are now £130,000 and will be split as follows:

X : Y : X = £26,000 : £52,000 : £52,000

Let us now look at each partner in turn:

X’s takes £86,000 from the partnership, of which £60,000 is a salary. He has no significant interest in the decision-making process and his capital investment  is less than 10% of his salary – hence X now becomes a junior partner and his salary must be dealt with under PAYE rules. His share of profit is an appropriation and must be declared under self-assessment. X is considered to be both employed and a partner.

Y and Z both fail the tests as they still retain a significant influence and hence are treated as senior partners under the appropriation rules, regardless of the other two rules.

Treating it this way does not change the amount that each partner earns, but it does have a significant effect on the way the accounts are finalised. X’s salary must be deducted as a business expense before the appropriation is carried out and reported under PAYE arrangements. The accounts become:

Net profit                                                            £300,000

Less partnership salaries under PAYE                       £60,000

Profits available for appropriation                          £240,000

Less partnership salaries:

Y                                              £50,000

Z                                              £60,000

                                                                        £110,000

                                                                        £130,000

Share of profits:

X                                             £26,000

Y                                             £52,000

Z                                             £52,000

                                                                       £130,000

These amounts will be transferred to the relevant capital accounts as before and the balance sheet produced.

Note: we have conveniently ignored the fact that the net profit available for appropriation would be further reduced by the amount of Employer’s NICs due on X’s salary that would also form part of the business expenses. Writer’s poetic licence taken!!

Conclusion

This article has looked at how the treatment of the profits (or losses) of a partnership differ from those of a sole trader. It looked in detail at how the appropriation of profits is carried out and at the separation of partners’ capital accounts from current accounts, as well as the effect that a loss can have on the capital situation of the business. It then considered the additional considerations regarding the appropriation of profits that must be taken when dealing with a limited liability partnership. It also pointed out that the subject of LLPs is extremely complex and the full treatment of the final accounts for submission to HMRC and Companies House is the subject of higher-level studies and should only be undertaken by those qualified to the appropriate level.

Jacquie Mount

Head of Technical Policy

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