Problem 1. Allocation of profits and determination of withdrawals.
Sandburg and Williams are the owners of a partnership that manufactures commercial lighting fixtures. Profits are allocated among the partners as follows:
|
|
Sandburg
|
Williams
|
|
Salaries
|
$100,000
|
$125,000
|
|
Bonus as a percentage of net income after the bonus
|
10%
|
0%
|
|
Interest on weighted-average capital including withdrawals and excluding current-year profits
|
5%
|
5%
|
Sandburg was divorced as of the beginning of 2015 and as part of the divorce stipulation agreed to the following:
- 1. The spouse is to receive annual distributions traceable to years 2015 and 2016. The annual distribution is to be the greater of $100,000 or 25% of base earnings.
- 2. Base earnings are defined as net income of the partnership less: (a) salaries traceable to Sandburg and Williams of $75,000 and $125,000, respectively, and (b) bonus to Sandburg as stated subject to the limitation that it not to exceed $50,000.
- 3. Sandburg's spouse would receive a distribution from the partnership on August 31 of each current year and on February 28 of each subsequent year. The August 31 target distribution is $50,000. If the August distribution is less than $50,000, Sandburg's spouse will receive one-half year's interest on the deficiency at the rate of 10% per year. The following distribution on February 28 must be of an amount such that the two distributions equal the required distribution traceable to the calendar year just ended plus any interest associated with the August distribution.
- 4. All distributions to Sandburg's spouse are to be considered as a withdrawal of capital by Sandburg.
- 5. Aside from distributions to Sandburg's spouse, Sandburg's annual withdrawals cannot exceed $125,000.
- 6. Upon sale or dissolution of the partnership prior to February 28, 2016, Sandburg's spouse would receive 50% of the net realizable value of Sandburg's partnership capital.
- 7. On February 28, 2017, Sandburg's spouse will receive an additional final distribution equal to 50% of the sum of Sandburg's capital balance as of December 31, 2016, less the amount of the February 2017 distribution as called for by item (3) above.
Capital balances at the beginning of 2015 were $180,000 and $125,000, respectively, for Sandburg and Williams. Activity related to the partnership during 2015 and 2016 is as follows:
|
|
2015
|
2016
|
|
Partnership net income
|
$750,000
|
$700,000
|
|
Distribution to Sandburg's spouse:
|
|
|
|
February 28
|
0
|
to be determined
|
|
August 31
|
40,000
|
50,000
|
|
Distributions to Sandburg:
|
|
|
|
June 30
|
60,000
|
125,000
|
|
September 30
|
65,000
|
0
|
|
Distributions to Williams:
|
|
|
|
June 30
|
30,000
|
300,000
|
|
September 30
|
90,000
|
20,000
|
Required
Prepare a schedule to determine the total amount of the distributions due Sandburg's spouse as of February 28, 2017. Note that the solution requires one to determine the amount of the February 2016 distribution to Sandburg's wife.
Problem 2. Evaluating whether or not to continue to share profits.
Raymond is a senior partner in a manufacturing firm and is approaching retirement age. In discussing succession planning with the company partners, two alternatives have been presented to Raymond. The first alternative would call for Raymond to receive a distribution of his share of current-year 2015 profits on March 31, 2016, along with a lump sum payment of $1,500,000 for his capital balance. The 2015 profit-sharing agreement is as follows:
|
Component
|
Raymond
|
Other Partners
|
|
Salaries
|
$125,000
|
$300,000
|
|
Bonus on income after the bonus
|
10%
|
0%
|
|
Percentage of remaining profits
|
40%
|
60%
|
The second alternative would consist of the following components:
- 1. A distribution of his share of current-year profits on March 31, 2016.
- 2. A distribution of his share of 2016-2017 profits on March 31 of each subsequent year. The profit-sharing agreement for 2016 and 2017 would be modified from the 2015 agreement as follows:
|
Component
|
Raymond
|
Other Partners
|
|
Salaries
|
$80,000
|
$350,000
|
|
Bonus on income after the bonus
|
0%
|
10%
|
|
Percentage of remaining profits
|
20%
|
80%
|
- 3. On March 31, 2018, Raymond would receive a lump sum payment of $1,700,000 for his interest in capital.
In order for Raymond to make an informed decision he has come to you seeking your advice on which alternative to accept. Raymond believes that they can invest all cash proceeds at a rate of 8% compounded annually. It is anticipated that the partnership will have income for years 2015-2017 of $550,000, $605,000, and $682,000, respectively.
Required
Prepare a schedule that compares the two alternatives and expresses the respective cash flows in terms of their present value as of March 31, 2016, assuming an 8% discount rate.