Factors for Personal Liability Under a Partnership

1300 words (5 pages) Essay in Law

18/05/20 Law Reference this

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Both the Securities and Exchange Commission (SEC) and the Generally Accepted Accounting Principles (GAAP) required publicly owned companies to disclose relevant business and financial information to the SEC, investors, creditors and buyers. The information to be disclosed includes, but it is not limited to, financial records, accounting policies, litigation in progress, lease information and pension plan funding (AICPA, 2006). When accounting for a litigation in process, disclosure laws required one to determine if the liability is probable, reasonably probable, or remote. If the liability is deemed probable and an amount can be estimated, the damages should be treated as a contingent liability and captured in financial statements prior to settlement. Under GAAP, ASC 450, a contingent liability is defined an expense that may occur as the result of a future event and the contingency loss should be accrued (Deloitte, 2019). Therefore, the company should accrue the monies by recording a debit to expense and a credit to liability in advance of the settlement. This transaction is reflected as an increase to expense on the Income Statement and will reflect as an increase to liabilities on the Balance Sheet. Since Target Corporation is currently involved in a lawsuit with an estimated $2,000,000 in probable damages, the company is required to reflect this amount on the financial statements. The company should record a debit to legal expense and a credit to accrued liabilities. Once the liability is realized and the balance is paid, Target would debit accrued liabilities and credit the cash account from which the monies were paid.

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In addition to accruing for the contingent loss, the company is also required to disclose the litigation in progress in the financial notes. All contingencies that could significantly alter the company’s estimated earnings, whether the amount can or cannot be reasonably estimated, must be must be disclosed in the financial notes. According to the FASB Standard No5 (1975), “the disclosure shall indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or state that such an estimate cannot be made”. Additionally, SEC regulations require disclosure of these suits to be contained on the quarterly 10-Q and Annual 10-K reports. In addition to the disclosure items required by FASB, the SEC also requires a company to name all “parties involved in the suit, describing the factual basis for the suit, provide the date the lawsuit was filed and the amount of damages the plaintiff is seeking” (Streissguth, 2019).

Companies that are privately owned are not required by law to disclose financial and operating information and are therefore not required to disclose lawsuits (Reardon, 2017). Since most partnerships are privately owned and not publicly traded, GAAP regulations to not apply. Accounting principles specific to partnerships are primarily based on traditional approaches that support the central governance for the partnership’s operations. This governance is outlined in the Articles of Partnership which is a negotiated agreement partners create that outline items such as rights and responsibilities, equitable treatment of partners, partner contributions used for valuation method, and the method by which profits and losses are to be allocated (Hoyle…). Therefore, when disclosing a lawsuit, the partners can decide what information, if any, they want to share with the public.  

Corporate shareholders are not personally liable for the company’s debts and other financial obligations as they are protected by limited liability (Hayes, 2019). Although shareholders are partial and residual owners of a firm, they do not manage the company’s operations. These activities are governed by a board of directors through appointed managers. Since shareholders are not involved in these business decisions, they are not at risk of being held personally liable when a company is involved in a lawsuit. However, should Target lose the lawsuit and suffer significant losses that impact earnings, cash flows, stock values, and dividend payments, the shareholders could lose the money they invested in the firm. If this situation should occur, the shareholder has the right to sue the company for the misdeeds of the directors and officers as outlined in the corporate charter and bylaws (Wahlen, 2017).

When determining personal liability under a partnership, the business structure defines the level of liability. Different partnerships structures include General Partnerships, Limited Partnerships (LP), and Limited Liability Partnerships (LLP). Under the General Partner Business structure, partners are personally liable for all business obligations. In Limited Partnerships (LP’s), limited partners are allowed to invest money as owners but are not allowed to make business decisions. Therefore, the general partner would be held liable for debts, but the limited partner would not. “The limited liability partnership has most of the characteristics of a general partnership except that is significantly reduces the partner’s liability” (Hoyle, ..). Under these structures, the partner can lose their investment and are responsible for any contractual debts of the business. However, should a lawsuit arise, an LLP protects a partner from being held personally liable for the misdeeds performed by other partners. Therefore, if Target was a partnership the partners could be at risk for personal liability depending upon the structure of the partnership.

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 Alternate business legal forms that provide protection from personal liability are Subchapter S Corporations and Limited Liability Companies (LLC). Subchapter S Corporations are created as a corporation and have all the legal characteristics of that form. This structure is similar to a partnership as the income and losses pass through to the taxable income of the individual owners. Conversely, under this form the owners do not face unlimited liability, but the shareholder will not be protected from any personal liability that arises from his own misdeeds (Chmielewski). Limited Liability Companies (LLC) are classified as partnerships for tax and court purposes and depending upon state law, the owners risk only their investment. Should a lawsuit occur, the LLC provides liability protection for its owners and managers.

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