Allocation strategies and the allocation of operating losses. Three individuals are considering forming a partnership to operate a metal fabricating shop. It is anticipated that significant contributions of capital will be necessary during the first 18 months of operation and that operating losses will likely be incurred during the first 12 months of operation. The three individuals have asked you to respond to each of the following questions they have regarding a partnership agreement:
1. It is anticipated that one of the partners will not be active in the day-to-day conduct of the business but will be a major contributor of capital. Assuming that interest on invested capital will be one of the profit allocation provisions, what would be the best way to measure the capital upon which interest will be calculated?
2. What are some of the factors that should be considered in setting the interest rate to be used when interest on invested capital is involved?
3. The individuals are considering addressing the buyout of an existing partner by merely stating that the withdrawing partner would receive a payment from the partnership equal to 120% of their capital balance measured as of the end of the month preceding their withdrawal. What are some concerns with this proposal?
4. If salaries are used as a component of a profit- or loss-sharing agreement, when are the salaries paid?Monthly, weekly, or on what basis?
5. If a bonus is used as a component of a profit- or loss-sharing agreement, why is it recommended that a bonus be based on income after the bonus?
6. The individuals understand that operating losses can be allocated either by (a) satisfying each provision to whatever extent possible or by (b) satisfying all provisions and then using the profit and loss ratios to absorb any deficiency. Which approach would you consider to be more equitable?
Respond to each of the above questions, keeping in mind that the individuals want to emphasize fairness over ease of application.
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