Question

Two friends are considering the formation of a partnership to operate a crafts and hobbies store. They have come to you to obtain information about the basic elements of a partnership agreement.

Partnership agreements usually specify an income and loss–sharing ratio. The agreements also may provide for such additional income and loss–sharing features as salaries, bonuses, and interest allowances on invested capital.

Required for Initial Discussion Post:

Discuss why a partnership agreement may need features in addition to the income and loss–sharing ratio. Discuss the advantages and disadvantages of recording salary and bonus allowances to partners as expenses included in computing net income.

Answer 1

Why a partnership agreement may need features in addition to the income and loss - sharing ratio ?

A partnership agreement may need features in addition to the income and loss-sharing ratio because other features may be useful in accounting for the various transactions in the partnership. For instance, a partnership may need an agreement on the valuation of the partners' contributed assets because this will determine the partners' capital account balances. It is also important to know if a liability, usually attached to a contributed asset, is to be assumed by the partnership. In the absence of income and loss-sharing ratio, the division of the partnership profits and losses will be based on this capital contribution ratio.

This capital contribution ratio may also be affected by an admission of a partner. A partner may be admitted through purchase of interest or by investing additional assets; hence, an important feature also is to determine the method of recording the contribution of assets. These methods - bonus method or goodwill method - may result in different capital balances.

Moreover, over the life of any partnership, partners may leave the organization; thus, some method of establishing settlement of the withdrawing partner's interest in the business property may also be an important feature.

Advantages of recording salary and bonus allowances to partners as expenses included in computing net income:

- Salaries and Bonus are considered as expense and allowed to be deducted while computing taxable income. So, recording salaries and bonus to partners upto allowable limits boost tax savings.

Disadvantages of recording salary and bonus allowances to partners as expenses included in computing net income:

- In a partnership, partners are entitled to the profit sharing based on their profit sharing ratio. Salaries are not actual income of the partners. So, Salaries are not considered partnership expenses but are part of the profit distribution plan.