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Accounting For Business Partnerships [Basic]

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Income Allocations in Business Partnership

The partnership agreement should include how the net income or loss will be allocated to the partners. If the agreement is silent, the net income or loss is allocated equally to all partners. As partners are the owners of the business, they do not receive a salary but each has the right to withdraw assets up to the level of his/her capital account balance.

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Some partnership agreements refer to salaries or salary allowances for partners and interest on investments. These are not expenses of the business, they are part of the formula for splitting net income. Many partners use the components of the formula for splitting net income or loss to determine how much they will withdraw in cash from the business during the year, in anticipation of their share of net income. If the partnership uses the accrual basis of accounting, the partners pay federal income taxes on their share of net income, regardless of how much cash they actually withdraw from the partnership during the year.

Once net income is allocated to the partners, it is transferred to the individual partners’ capital accounts through closing entries.

Case Example

Assume Lie’s Consultants, Inc., a partnership, earned $60,000 and their agreement is that all profits are shared equally.

Each of the three partners would be allocated $20,000 ($60,000/3)

 

The journal entry to record this allocation of net income would be:

Dec.31 20X0

[Debit]. Income Summary = 60,000
[Credit. Lie, Capital = 20,000
[Credit]. Lauw, Capital = 20,000
[Credit]. Jeanette, Capital = 20,000
(Note: To record transfer net income to partner’s capital accounts)

Remember that allocating net income does not mean the partners receive cash. Cash is paid to a partner only when it is withdrawn from the partnership.

 

In addition to sharing equally, net income may also be split according to agreed upon percentages (for example, 50%, 40%, and 10%), ratios (2:3:1), or fractions (1/3, 1/3, and 1/3). Using Lie’s Consultants net income of $60,000 and a partnership agreement that says net income is shared 50%, 40%, and 10% by its partners, the portion of net income allocated to each partner is simply the $60,000 multiplied by the individual partner’s ownership percentage.

Using this information, the split of net income would be:

Lie                     50%          $30,000
Lauw                 40%            24,000
Jeanette             10%              6,000
Total net income                $60,000

 

Using the 2:3:1 ratio, first add the numbers together to find the total shares (six in this case) and then multiply the net income by a fraction of the individual partner’s share to the total parts (2/6, 3/6, and 1/6). Using the three ratios, the $60,000 of Lie’s Consultants net income would be split as follows:

Lauw            2/6          20,000
Lie                3/6         $30,000
Jeanette        1/6           10,000
Total net income        $60,000

Using the fractions of 1/3, 1/3, and 1/3, the net income would be split equally to all three partners, and each partner’s capital account balance would increase by $20,000.

 

Assume the partnership agreement for Lie’s Consultants requires net income to be allocated based on three criteria, including salary allowances of $15,000, $12,000, and $5,000 for Lie, Lauw, and Jeanette, respectively; 10% interest on each partner’s beginning capital balance; and any remainder to be split equally.

Using this information, the $60,000 of net income would be allocated $21,000 to Lie, $20,000 to Lauw, and $19,000 to Jeanette.

 

Information from the owners’ capital accounts shows the following activity:

                  Beginning         Additional            Withdrawals
                  Capital              Investments          During Year
                  Balance             During Year

Lie            $ 20,000           $ 5,000                  $15,000
Lauw           40,000              5,000                    10,000
Jeanette     100,000            10,000                      5,000
Allocation of Net Income of                            $60,000

 

                                     Lie           Lauw       Jeanette      Total

Salary Allowances       $15,000   $12,000   $ 5,000       $32,000
Interest (10% of              2,000       4,000     10,000         16,000
beginning capital
account balance)
                                     17,000     16,000     15,000         48,000

Remainder (equally)       4,000       4,000       4,000          12,000
Net Income                 $21,000   $20,000   $19,000       $60,000

 

The investments and withdrawal activity did not impact the calculation of net income because they are not part of the agreed method to allocate net income. As can be seen, once the salary and interest portions are determined, they are added together to determine the amount of the remainder to be allocated. The remainder may be a positive or negative amount.

Assume the same facts as above except change net income to $39,000. After allocating the salary allowances of $32,000 and interest of $16,000, too much net income has been allocated. The difference between the $48,000 allocated and the $39,000 net income, a decrease of $9,000, is the remainder to be allocated equally to each partner. These assumptions would result in allocations of net income to Lie of $14,000, Lauw of $13,000, and Jeanette of $12,000. The calculations are as shown:

 

Allocation of Net Income of $39,000

                                 Lie          Lauw        Jeanette    Total
Salary allowances    $15,000   $12,000  $5,000     $32,000
Interest (10% of          2,000       4,000   10,000       16,000
beginning capital
account balance)
                                  17,000     16,000   15,000       48,000

Remainder (equally)    (3,000)     (3,000)  (3,000)       (9,000)

Net Income              $14,000   $13,000  $12,000    $39,000

 

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Changes in Partners

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