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.

Specifically, the following critical elements must be addressed:

I. Allocation of Profits

     A. Explain how allocating the profits evenly between the partners would work. Consider the fairness to each of the partners in your response.
     B. What would be the value of each partner's capital account at the end of the year, given that the profits were allocated evenly among the three? Support your answer with quantitative data and an explanation of how you came to this conclusion.
     C. Explain an alternative method of allocating the profits if 80% of the profits was given to the cash investor and the remaining amount was split evenly between the other two partners.
     D. What would be the value of each partner's capital account at the end of the year, given this alternative allocation method? Support your answer with quantitative data and an explanation of how you came to this conclusion.

II. 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 all be 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