302463 PARTNERSHIP PROFITS 2I Flashcards
Ace and Zent formed a partnership in 20X8. The partnership agreement provides for annual salary allowances of $63,000 for Ace and $27,000 for Zent. The partners share profits and losses in a 30/70 ratio. The partnership had earnings of $126,000 for 20X8 before any allowance to partners. What amount of these earnings should be credited to each partner’s capital account?
Ace: $10,800; Zent: $25,200
Ace: $73,800; Zent: $52,200
Ace: $63,000; Zent: $27,000
Ace: $37,800; Zent: $88,200
Ace: $73,800; Zent: $52,200
Salaries are paid (as an expense) to the partners before partnership earnings are allocated:
Allocation
To Ace To Zent
Salary allowance $63,000 $27,000
Profit allocation
To Ace (.30 × $36,000) 10,800
To Zent (.70 × $36,000) 25,200
Partnership
A partnership is an association of two or more persons to carry on as co-owners of a business for profit. Partnerships are governed in the various states of the United States by the Uniform Partnership Act (UPA). A partnership may be general, limited, or joint venture.
Characteristics of a partnership include the following:
- Voluntary association of persons as individuals (the partnership has no separate legal identity under common law, but under the UPA it is now an entity for most purposes)
- Simple agreement without governmental sanction
- A fiduciary relationship (mutual agency—each partner is an agent for the others and for the partnership)
- Co-ownership
- Mutual agency of partners
- Joint and several liability
A partnership does not pay income tax. It is a pass-through entity, so profits and losses of the partnership pass through to its partners. A partnership does file an informational tax return using IRS Form 1065, U.S. Return of Partnership Income.
Profits Interest
The profits interest or percentage is the percentage interest that a partner will share in the profits of the partnership for the year. This percentage can vary as the partnership agreement is amended. The mere right to share in earnings and profits of a partnership is not the same as a capital interest in a partnership. A capital interest in a partnership can be contrasted to a “profits interest” where the owner of such an interest only shares in the profits and losses of the company and the partner with the profits interest has no claim against the assets of the partnership in the event of a liquidation.
2296.05
The capital and drawings accounts, kept separately for each partner, increase and decrease as a result of various activities, such as the following:
Capital Account
Decrease: Increase:
Disinvestment by partner Investments of assets by partners
Partner’s share of net loss Partner’s share of net income
Close of drawings into capital account
Drawings Account
Increase: Decrease:
Withdrawal of assets by partner Drawings closed into capital
account
Numerous other situations, such as admission and retirement of partners and liquidation, also result in changes in the capital accounts.
2296.06
If there is no statement in the partnership agreement concerning profit or loss distribution, all partners share equally in both profits and losses. Several factors, however, are frequently considered in establishing an agreement on profit or loss division:
Relative asset investment of partners
Relative time (service) investment of partners
Relative experience, expertise, and education of partners
2296.07
Agreements on the distribution of income or loss typically include some combination of the following: salaries to some or all partners, interest on capital balances, bonus to managing partner, and distribution of any residual in a fixed or determinable ratio.
2296.08
Example: H and J are partners who agree to share all profits and losses according to the following plan:
5% bonus on income (after bonus) to H as managing partner (not applicable in net loss situations)
10% interest to each on the average capital balance
Salaries of $20,000 to H and $15,000 to J
Remainder divided equally
Average capital balances during the year 20X1 for H and J were $50,000 and $75,000, respectively. In Case A, income before bonus is $100,000; in Case B, net loss is $25,000.
2296.09
The basis for allocation may include numerous steps; the cases mentioned previously are included here for illustrative purposes. It can be seen that the step-by-step procedure should be followed in cases of net income as well as net loss. In some cases, the balance to distribute might start as positive and become negative as you move through the steps. This would be the case in the previous example if net income were not large enough to absorb the bonus of step 1, the interest of step 2, and/or the salaries of step 3. The same procedure, however, should be followed with any residual negative balance distributed to the partners’ capital accounts, as was done in case B.
