Question

A new business client comes to your office. There are three owners of the business. The three individuals, Alan, Bob, and Carol, are thinking about forming a partnership. Alan is only investing $1 million in cash. He will not have anything to do with the daily activities of the business. Bob has had some experience in the business and will be responsible for the day-to-day operations of the business. Carol has a great deal of experience and many contacts within the business. She will be responsible for attracting new clients. Neither Bob nor Carol are investing cash into the partnership. During the first year of operation, the partnership generated a profit of $150,000. None of the partners received distributions during the year.

Payment of Salary

A. Should the two partners who are working in the business receive a salary? Why or why not? Be sure to support your decision with research and quantitative data.

B. If the two non-investors did receive a salary, how would their capital account be affected? How would this impact a potential future liquidation or buyout? Be sure to thoroughly explain and support your answer.

C. Should the cash investor receive a higher share of the profits or other sharing options? Why or why not? Support your opinions with research and quantitative data.

D. If the cash investor did receive a salary, how would his capital account be affected? How would this impact a potential future liquidation or buyout? Be sure to thoroughly explain and support your answer.

E. How do the payment of salary and the allocation of profit affect entries and the financial bottom line? Be sure to support your explanation with concrete examples.

F. How could the payment of salary and allocation of profit be a more effective method of splitting the company's profits for the three partners? Explain a scenario in which the three partners would be all compensated fairly, and support your answer with logical reasoning.

G. What would be the value of each partner's capital account at the end of the year, given your proposed fair allocation method? Support your answer with quantitative data and an explanation of how you came to this conclusion.

Answer 1

A. Yes, the two partners Bob and Carol who are working in the partnership firm/business should receive a salary.

In a partnership, there are two types of partners, a Working Partner and another one a Sleeping Partner. The partner who is working and taking care of the daily operations of the business is called Working Partner and the one who is sleeping or is silent is called Sleeping Partner. The sleeping partner only invests the money and does not do any managerial or administrative work and is not involved in day to day work of the firm. On the other hand, a working partner manages the business so they should be paid in form of salary. The salary expense should be deducted and the profit earned if any can be divided among all the partners (Sleeping and Working) on the basis of their profit sharing ratio.

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B. The amount of salary the working partner will receive will be credited in their respective Capital account and any amount withdrawn by the partner will be debited in form of Drawings in the capital account.

In the case of future liquidation or buyout, the assets are distributed based on the priority of claims by various parties. First preference is given to secured creditors, then to unsecured creditors and finally if anything is left then it is distributed among the partners as per their capital balance as on that date.

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C. No, the cash investor should not receive a higher share of the profits. Profit should be distributed as per the profit sharing ratio as per the partnership deed.

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D. Salary amount will be credited in capital account as well as the investment amount made by the partner. This will increase the balance of the capital account of investing partner and hence at the time of future liquidation the investing partner may receive more asset distribution as compared to other owners.

For example, Alan invested $1 million.

Salary of Alan is $24000 annually, Bob is getting $36000 annually and Carol is getting $ 40000

Their annual drawings are $15000, $32000, $35000 respectively. So their capital account at the end of the accounting year will be as,

Amount in $

Particulars (Dr.)	Alan	Bob	Carol	Particulars (Cr.)	Alan	Bob	Carol
To Drawings	15,000	32,000	35,000	By Cash (amount invested)	1 million	0	0
				By Salary	24,000	36,000	40,000
To balance c/d	10,09,000	4,000	5,000
Total	10,24,000	36,000	40,000		10,24,000	36,000	40,000