A client approached us recently to help with the dissolution of partnership accounting work required for their tax reporting. In the dissolution of the partnership, we had to prepare the accounting entries and a set of accounts and help with their income tax and the partnership’s goods and services tax obligations. Having done all of this work, we thought it might be a useful example to write about, and others might find it helpful if they had to do similar work.
Background Information
A client in New Zealand approached us for some help in the dissolution of a small farming partnership. As part of the winding-down process, the essential business activity of the partnership, sheep breeding, was being sold to a family trust. The partners are to receive any remaining assets in the business.
Facts of the work involved:
- there are two main parts to the sale.The first part is livestock and second part is the land and improvements, plant and equipment and motor vehicles;
- the sale price of the livestock was agreed at $4,000 and the equipment, tools and vechicle for a combined $4,655;
- the sale date was July 31, and;
- both parties are registered for GST and are domiciled for New Zealand income tax.
What is a Partnership?
A lot of New Zealand law stems from English law, which is very common around Commonwealth Countries. And in terms of business partnerships, they are very similar in definition, structure and legal treatment worldwide (again, stemming from English law). New Zealand partnerships are governed by the Partnership Law Act 2019. Under s.8, the Act defines a partnership as a “… relationship that exists between persons carrying on a business in common with a view to profit”. And then under s.9 goes onto exclude relationships that are not partnerships, particularly companies and limited partnerships.
So in our humble real-life example, a couple set up a two-person partnership many years ago to operate a small sheep breeding business. At any one time, this would only be about 40 breeding ewes, with somewhere around 60 to 80 lambs born from each breeding season. Income was derived from wool and lamb sales each year, along with some hogget and mutton sales.
What is a Trust?
Trusts in New Zealand are governed by the Trusts Act 2019. A trust is not a separate legal entity in most countries like a company is under the Companies Act 1993. A trust comprises three components. A settlor transfers property to the trust and establishes the trust deed — a trustee is responsible for the operation of the trust according to the deed and legislative requirements. And beneficiaries, the parties who are to benefit from the trust’s activities.
How Does Goods and Services Tax Come Into It?
In New Zealand, they operate an indirect tax called goods and services tax (GST). This tax applies to most goods and services sales in New Zealand, with a few exceptions such as financial transactions, exports and private dwelling rental receipts and payments. GST is a final consumer tax, so GST registered businesses effectively act as tax agents for their Inland Revenue Department (IRD). According to the Royal Malaysian Customs Department, 160 countries operate a GST/VAT (Value Added Tax) regime. So they are widespread around the world. However, an interesting exception to this large group is the United States.
How Do We Account For Income Tax?
As the sale is two main components, we’ll look at the income tax question the same way.
Fixed Assets (non-livestock)
The fixed assets sold fall into three groups; land and improvements, plant and equipment and motor vehicles. These assets were depreciating on a straight line or diminishing value basis over their economic lives. The rates applied were as per tax allowances issued by the IRD. If you would like a guide on depreciating fixed assets, you can find our accounting tutorial here.
The snapshot below (taken from 31 March 2021 accounts) shows the partnership’s fixed asset register (FAR). From this, the agreed sale price was established for the non-livestock assets, using the “closing book” values as the agreed purchase price. You can see the different rates of depreciation applied to the various classes of assets. The rates were either applied using a straight line (SL) or diminishing value (D).
Where these assets are selling for above book value, we, in effect, have depreciation recovered on sale. And the tax office would like its cut back. So, income tax is due on the difference, where we have claimed depreciation, which is an expense beyond what we can sell the asset for. However, in our case, the book value and the market value were deemed to be similar enough. The carrying book value seemed appropriate to use at these small asset values and the age of many assets.
So for this situation, there is no income tax payable on the sale of the fixed assets. But there is on the livestock, and that is covered below.
Livestock
The livestock being sold are all sheep, with the different classes for tax purposes set out below in a snapshot taken from the accounts prepared for sale as of 31 July 2021. The per head figures are from the National Average Market Values (NAMV) of Specified Livestock figures, released by the IRD each year. This link takes you to the 31 March 2020 figures. The IRD states:
These NAMVs are used by taxpayers that are in the business of livestock farming to value their livestock on hand, where the taxpayer has elected to use the herd scheme to value livestock in an income year.
New Zealand uses two schemes for valuing livestock for tax purposes; the herd scheme and the national standard cost scheme. If you would like to know more about these, please use this link. We’ll hopefully get an article together about this sometime in the future.
We won’t go into what the different classes of sheep mean. But suffice to say they reflect the economic values of the animals at their different ages and are split between male and female. For example, a mixed-age (MA) ewe is more valuable than similar-aged wethers or rams.
Based on prevailing market conditions and a slight change in sheep numbers, the agreed purchase price for the livestock was $4,000. For income tax purposes, this $4,000 will be subject to income tax – as if in the ordinary course of trade.
An important note to make here is how does the partnership pay income tax? Well, it doesn’t. As all profits and losses are distributed to the partners each year, the tax is paid at the individual taxpayer level at their effective marginal rate. So we won’t be seeing any income tax journal entries as there are none to deal with.
Journal Entries of Partnership Dissolution
The journal entries we cover below relate to the process going on. The first will be the sale of the going concern to the family trust. While the second is the dissolution of the partnership. The two processes are connected, so you will have common accounts used.
Sale of Going Concern
Livestock
The first journal entry recognises the sheep sales. The trust owes the partnership $4,000, and the partnership treats the transaction as income. This treatment would be the same as if the partnership sold the sheep in the ordinary course of its trade.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Accounts Receiveable | 4,000 | |
| | Sheep Sales | | 4,000 |
The sheep’s stock on hand asset account had a balance of $4,962 (as you saw from the 31 March 2021 snapshot above). This account has to be closed as the sheep have now been sold.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Retained Earnings | 4,962 | |
| | Sheep on Hand | | 4,962 |
Fixed Assets
We now move onto the fixed assets being sold. The first step is to clear the fixed asset account and move it to a disposal account. This will enable us to clear both the costs and the accumulated depreciation.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Fixed Asset Disposal Account | 18,743 | |
| | Fixed Assets (at cost) | | 18,743 |
As we have cleared the fixed assets to the disposal account, we will do the same with the accumulated depreciation.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Accumulated Depreciation – Land & Improvements | 2,563 | |
| | Accumulated Depreciation – Plant & Equipment | 3,555 | |
| Accumulated Depreciation – Motor Vehicles | 7,970 | ||
| Fixed Asset Disposal Account | 14,088 |
We have the “net fixed assets” in effect in the disposal account; we can process this balance for sale. As with the livestock, an account receivable is raised, reflecting the money the partnership is owed.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Accounts Receivable – for Fixed Assets | 4,655 | |
| | Fixed Asset Disposal Account | | 4,655 |
Dissolution of the Partnership
Now that we have the sale process out of the way, we can turn our attention to the dissolution of the partnership accounting work – from what is left on balance. Below is a copy of the 31 March 2021 balance sheet. You can see some of the items have already been dealt with, i.e. the fixed assets and livestock. We now have to work our way through the remaining accounts to bring it all together. Note that between 31 March 2021 and the winding up on 31 July, there were no transactions.
Realisation of Assets
The first journal we need to prepare is closing the remaining three accounts: current accounts, bank and investment shares. The balances from these accounts will be taken to the realisation account. The account’s name matters little, as long as it is clear what it is being used for. Some will call this account the dissolution account, which makes sense too.
In the first dissolution journal entry, we have the following debit and credits. The asset accounts are being closed off, except the bank account, to the realisation account. The bank is being left for the moment as we need this to remain open for any payment to or from the partners.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Realisation Account | 9,745 | |
| | Investment Shares | 1,090 | |
| Accounts Receivable – Sheep | 4,000 | ||
| Accounts Receivable – Fixed Assets | 4,655 |
The investment shares figure comes from the balance sheet extract listed above. The two accounts receivable accounts come from the sale process and the monies owed from the family trust to the partnership.
Realisation of Liabilities
The next step would normally be to transfer the liability accounts to the realisation account. However, we don’t have any with this partnership to prepare a journal entry for.
Closure of Retained Earnings
This partnership was not maintaining any profit or loss, i.e. retained earnings, as the partners cleared these each year. But what we have sitting in the accounts is the sale of the sheep and the associated loss on disposal. From the Sale of Going Concern process, you will recall we had $4,000 in revenue and a clearing of the stock on hand account of $4,962. These two added together would be a retained earnings balance of $962 debit, and this is the amount we now need to clear to the partners’ capital account.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Partners Captial Accounts | 962 | |
| Retained Earnings | 962 |
Assets Aquired by Partners
In our example, the partners took over the accounts receivable and share investment. So our next journal entry is to reflect the transfer of these assets to their current accounts. We have had to create the Partners Capital account, as the partnership did not maintain this. We will be clearing the current accounts through this shortly.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Partners Captial Accounts | 9,745 | |
| Realisation Account | 9,745 |
Transfer of Partner Current Accounts
Our next step is to close off the partners’ current accounts, which we will do through the capital accounts. After this journal entry, all we will have open is the bank account and the capital accounts. As the current accounts were in credit, we close them with a debit entry and a respective credit to the capital accounts.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Partners Current Accounts | 11,301 | |
| Partners Captial Accounts | 11,301 |
Closing Partner Capital Accounts
With the current accounts closed, we now only have the capital accounts to close off, a payout of $594 to the partners. The respective debit and credit will bring both of these balances to $0.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 31 | Partners Captial Accounts | 594 | |
| Bank | 594 |
Conclusion
And that brings us to the end of the exercise and the process we worked through for the client. Dissolution of partnership accounting isn’t too taxing but more a process of working through the steps. The accounting entries reflect the business processes to distribute the business’s net assets to the partners.
We haven’t covered all of the possible transactions that may need to prepare journal entries for. However, we have given you a good overview of dealing with most situations you will face. If you have any questions about this example or want to see other journal entries covered, please contact us through the comments below or our contact us page.