In business, a partnership is when two or more individuals share the management and ownership of a company. In order to correctly allocate income in a partnership, there are a number of steps to follow on the income statement and balance sheet.
First, the net income of the business is calculated; then, this income is allocated among the partners based on the method chosen and the rules stipulated in the company’s business documentation. It’s important to correctly follow these steps to keep proper books and ensure taxes are done accurately.
Taxing a Partnership and Impact on Allocations
Partnerships can be a great way to start a small business because doing so can pool resources from multiple individuals. The risks and responsibilities of the company are then shared among the partners as well. Often, these partners have different things to offer in terms of resources. Thus, the partnership is rarely an equal one-to-one transaction. In these cases, a business has to be aware of how to balance income and profit among the partners.
A business registered as a partnership does not pay tax on its income. Instead, the responsibility for taxes passes through to the individual owners, who will pay taxes on their personal shares of net income (or net loss) as part of their individual tax filings. This differs from a corporation because corporations pay taxes on their income, but their owners have a degree of separation for their individual tax returns.
Because the partnership passes on the responsibility to the individual filers, it’s important that each partner is reporting his proper share of income from the business on his personal tax forms. The portion of income assigned to each partner is called an allocation. In simple cases, the income may be divided equally among partners, but this is not always the case.
Special Allocation of Partnership Income
Within a business run as a partnership, special allocations occur when the profits and losses of the company are distributed among owners differently than they might be based simply on percent of ownership. This happens when partners may want to share ownership 50/50 but, for example, one partner has provided more initial startup capital and has thus been allocated a higher percentage of the profits. These special allocations must be recorded specifically and accurately to avoid issues with taxes.
Because special allocations change the way profits are distributed and thus the way individuals are taxed, they can come under special scrutiny from the IRS to make sure the allocations are being done for a business reason rather than a taxation reason.
Examples of Partnerships and Allocated-Income Statements
For example, two individuals open a partnership together with equal shares of ownership; one has her share of the startup money ready, while the other will need three years to come up with her portion. They decide that over those three years, the first partner will receive a higher percentage of the profits from the business since she has more capital invested. Once the investments are equal, the profit sharing will reset to reflect that. This example carries a legitimate business reason and would be acceptable to the IRS.
As another example, say two partners have invested equal money and share equal ownership, but one partner is to be more active in running the business while the other is less involved. They decide that for the first five years of the business, the more-active partner should get a higher percentage of the net income due to the more-significant time investment.
If this is documented, this is also an acceptable business reason to divide allocations unevenly. What isn’t acceptable is to divide net income among partners in a way that lessens one or more partner’s tax burden without a business reason to justify it.
Partnership Allocated-Income Statements
When determining allocation of net income to partners, you must first calculate the net income of the business. Next, this income is allocated among the partners. The way this is done will vary depending on how the company set up its partnership and the rules it documented for calculating allocated income at that time.
Net-Income Calculation and Closing Entries
Net-income calculation and closing entries allow the calculation of net income for a partnership. This is the typical way of looking at the income statement to determine net income:
- Sum the company’s revenues, such as sales and interest income.
- Sum the company’s expenses, such as rent, utilities, marketing, salaries and cost of goods sold.
- Subtract the expenses from the revenues to determine net income. (If this is negative, then the company has taken a net loss.)
- To close out the income statement:
Net-Income Distribution to Partners
From here, this net income is to be allocated to the partners. There are three general approaches to income distribution: equal allocation, ratio-based allocation and salary- and capital-based allocation. Each of these uses a different method of approach depending on the complexity of the situation as determined by the partnership agreement.
Once the net income has been allocated, the income summary account is then closed by debiting each allocation and crediting it to the respective partner’s capital account.
This accounting process remains the same if the net profit is in fact a net loss; losses are to be distributed in the same way as profits as determined by the partnership agreement. No matter how the allocations are calculated, the process for clearing the income statement remains the same. However, in order to track correctly, that net income does have to be allocated between partners properly.
Methods of Allocating Net Income
The method used to calculate allocations among partners should be clearly stated in the partnership agreement and other business documentation. The methods can change from year to year if necessary as long as the changes are voted on and approved by the relevant parties per the partnership agreement.
For example, if one partner decides to make an additional capital investment, it may require a new allocation method to be chosen or a change in the ratios used for a specific period of time. Remember that it’s important to be sure there’s a business reason for allocations.
Equal allocation simply and straightforwardly divides net income equally among all partners. This method is used when partners’ contributions to startup capital have been equal or are not significant enough for the partners to require additional allocations to be made.
For example, a company with three partners whose net income is $12,000 would allocate $4,000 to each partner under net income. This $4,000 is debited from the income-summary account and credited to each partner’s individual capital account.
Ratio-based allocation uses a ratio of either the beginning capital balance or the current capital balance to allocate profits. This is usually used when partners have provided unequal amounts of startup capital, and the partnership has agreed to reflect this fact by allocating income.
For example, a company with three partners has a net income of $12,000 and are using the ratio of their initial capital balance in order to allocate profits. In this case, their initial startup capital was $2,000 provided by partner A, $1,000 provided by partner B and $1,000 provided by partner C. This leaves them with a ratio of 2:1:1 A:B:C for the distribution of profits. Applying this ratio to the $12,000 net income means:
- A will receive $6,000 of net income
- B will receive $3,000 of net income
- C will receive $3,000 of net income
These values are then debited from the income-summary account and credited to each partner’s capital account respectively.
Combination Method of Allocation
The combination method of allocation is the most complicated and uses salaries, capital and interest allowances and ratios to determine how to allocate profits. There are three parts of this method to consider:
- Salary: In this case, the partners have declared salary allowances ahead of time that will be drawn from profit at this point rather than (or in addition to) any salary pulled into expenses earlier in the balance sheet. Interest allowances can also be declared in the partnership agreement if relevant to that type of business.
- In addition, partners can choose to add an allocation based on the initial capital investments. The agreement can state that some portion or percentage of the net income is to be distributed at this ratio.
- Finally, partners can choose to distribute the remaining net income equally between all or by another ratio as set out in the agreement.
Example of the Combination Method
To continue the example, consider a partnership agreement declaring A’s net-income salary allowance as $2,000, B’s as $1,000 and C’s as $1,000. This is a $4,000 total salary distribution to be taken from their $12,000 net income, which will be allocated to their individual capital accounts, leaving $8,000 of net income to be divided.
In addition, the partners have chosen to allocate a remaining 50% of net income in the ratio of their original capital investments, stated to be 2:1:1 A:B:C. Fifty percent of the remaining $8,000 creates $4,000 to be allocated this way: $2,000 to A and $1,000 each to B and C. This is again credited to each individual account and leaves $4,000 of net income left.
The partners have agreed that any remaining net income is to be divided equally. The remaining $4,000 is then divided three ways, giving each partner $1,333 that is again credited to their capital accounts.
Example Income Statement
The income statement for this example would then include the following transactions as debits to the income-summary account and credits to each partner’s individual account:
- Partner A: $2,000 salary + $2,000 capital allowance + $1,333 remaining allocation = $5,333 total
- Partner B: $1,000 salary + $1,000 capital allowance + $1,333 remaining allocation = $3,333 total
- Partner C: $1,000 salary + $1,000 capital allowance + $1,333 remaining allocation = $3,333 total
Note that $5,333 + $3,333 + $3,333 adds up to the total initial net income of $12,000 reported by the company on its income statement.
The benefits to this final method are that the partners can be recognized separately for their time put into the business by salary, their initial capital investment in the business and their ownership of the company. The downside is, obviously, that this can make the calculations more difficult, although it can all be broken down into simple transactions on the income statement.
Allocating Net Income With No Payout
In the early years of a small business, partners may decide to reinvest all of their net income into the company rather than taking any payout of that profit for themselves, or they may choose a partial reinvestment and a partial income per some predetermined ratio.
This also needs to be fairly represented on their individual tax returns. Even if everything is still reinvested into the company, the partners are still responsible for listing their allocated share of the net income as personal income on their tax return because it represents money each partner made and then put back into the business. This is another area the IRS watches closely to be sure no tax fraud is occurring; otherwise, companies could reallocate profits in order to avoid paying individual taxes.