EX 12-6 Negotiating income-sharing ratio
Sixty-year-old Mary Filmore retired from her computer consulting business in Boston and moved to Florida. There she met 27-year-old Emily Wright, who had just graduated from Eldon Community College with an associate degree in computer science. Mary and Emily formed a partnership called F&W Computer Consultants. Mary contributed $35,000 for startup costs and devoted one-half time to the business. Emily devoted full time to the business. The monthly drawings were $2,000 for Mary and $4,000 for Emily.
At the end of the first year of operations, the two partners disagreed on the division of net income. Mary reasoned that the division should be equal. Although she devoted only one-half time to the business, she contributed all of the startup funds. Emily reasoned that the income-sharing ratio should be 2:1 in her favor because she devoted full time to the business and her monthly drawings were twice those of Mary.
a. Can you identify any flaws in the partners’ reasoning regarding the income-sharing ratio?
b. How could an income-sharing agreement resolve this dispute?
Answer:
a. The partners can divide net income in any ratio that they wish. However, in the absence of an agreement, net income is divided equally between the partners. Therefore, Mary’s conclusion was correct, but for the wrong reasons. In addition, note that the monthly drawings have no impact on the division of income. These drawings are not the same as a salary allowance, which is part of a formal income-sharing agreement.
b. An income-sharing agreement could be designed to credit each partner’s capital account for his or her respective contributions. For example, an income-sharing agreement could be designed to credit Mary’s capital account for interest on her capital contribution, while a salary allowance could be designed to credit Emily for the greater effort she puts into the partnership. After deducting for these items, the remaining income could be divided equally.
At the end of the first year of operations, the two partners disagreed on the division of net income. Mary reasoned that the division should be equal. Although she devoted only one-half time to the business, she contributed all of the startup funds. Emily reasoned that the income-sharing ratio should be 2:1 in her favor because she devoted full time to the business and her monthly drawings were twice those of Mary.
a. Can you identify any flaws in the partners’ reasoning regarding the income-sharing ratio?
b. How could an income-sharing agreement resolve this dispute?
Answer:
a. The partners can divide net income in any ratio that they wish. However, in the absence of an agreement, net income is divided equally between the partners. Therefore, Mary’s conclusion was correct, but for the wrong reasons. In addition, note that the monthly drawings have no impact on the division of income. These drawings are not the same as a salary allowance, which is part of a formal income-sharing agreement.
b. An income-sharing agreement could be designed to credit each partner’s capital account for his or her respective contributions. For example, an income-sharing agreement could be designed to credit Mary’s capital account for interest on her capital contribution, while a salary allowance could be designed to credit Emily for the greater effort she puts into the partnership. After deducting for these items, the remaining income could be divided equally.
