At the end of the first year of operations, the two partners disagreed on the division of net income. Wanda reasoned that the division should be equal. Although she devoted only one-half time to the business, she contributed all of the startup funds. Ava 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 Wanda.
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, Wanda’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 share of income. For example, an income-sharing agreement could be designed to credit Wanda for interest on her capital contribution, while a salary allowance could be designed to credit Ava for the greater effort she puts into the partnership. After deducting for these items, the remaining income could be divided equally.