Question

HOW WILL THE PROFITS BE SPLIT?

James J. Dewars has been the sole owner of a small CPA firm for the past 20 years. Now 52 years old, Dewars is concerned about the continuation of his practice after he retires. He would like to begin taking more time off now although he wants to remain active in the firm for at least another 8 to 10 years. He has worked hard over the decades to build up the practice so that he presently makes a profit of $180,000 annually.

Lewis Huffman has been working for Dewars for the past four years. He now earns a salary of $68,000 per year. He is a very dedicated employee who generally works 44 to 60 hours per week. In the past, Dewars has been in charge of the larger, more profitable audit clients whereas Huffman, with less experience, worked with the smaller clients. Both Dewars and Huffman do some tax work although that segment of the business has never been emphasized.

Sally Scriba has been employed for the past seven years with another CPA firm as a tax specialist. She has no auditing experience but has a great reputation in tax planning and preparation. She currently earns an annual salary of $80,000.

Dewars, Huffman, and Scriba are negotiating the creation of a new CPA firm as a partnership. Dewars plans to reduce his time in this firm although he will continue to work with many of the clients that he has served for the past two decades. Huffman will begin to take over some of the major audit jobs. Scriba will start to develop an extensive tax practice for the firm.

Because of the changes in the firm, the three potential partners anticipate earning a total net income in the first year of operations of between $130,000 and $260,000. Thereafter, they hope that profits will increase at the rate of 10 to 20 percent annually for the next five years or so.

How should this new partnership allocate its future net income among these partners? As well as a solution for the specific example

Answer 1

​​Answer:

Allocation of Income:

Understand the impact that the allocation of partnership income has on the partners' individual capital balances.

At the end of each fiscal period, partnership revenues and expenses are closed out, accompanied by an allocation of the resulting net income or loss to the partners' capital accounts. Because a separate capital balance is maintained for each partner, a method must be devised for this assignment of annual income. Because of the importance of the process, the articles of partnership should always stipulate the procedure the partners established. If no arrangement has been specified, state partnership law normally holds that all the partners receive an equal allocation of any income or loss earned by the business. If the partnership agreement specified only the division of profits, then losses must be divided in the same manner as directed for profit allocation

An allocation pattern can be extremely important to the success of an organization because it can help emphasize and reward outstanding performance.

The goal of a partner compensation plan is to inspire each principal's most profitable performance-and make a form grow. When a CPA firm's success depends on partner contributions other than accounting expertise- such as bringing in business, developing a specialty or being a good manager-its compensation plan has to encourage those qualities, for both fairness and firm?s health.