After graduating from college, Shelley Williams held several different jobs but found that she did not enjoy working for other people. Finally, she and Yvonne Hargrove, her college roommate, decided to start a business of their own. They rented a small building and opened a florist shop selling cut flowers such as roses and chrysanthemums that they bought from a local greenhouse.
Williams and Hargrove agreed orally to share profits and losses equally, although they also decided to take no money from the operation for at least four months. No other arrangements were made, but the business did reasonably well and, after the first four months had passed, each began to draw out $500 in cash every week.
At year-end, they took their financial records to a local accountant so that they could get their income tax returns completed. He informed them that they had been operating as a partnership and that they should draw up a formal articles of partnership agreement or consider incorporation or some other legal form of organization. They confessed that they had never really considered the issue and asked for his advice on the matter.
What advice should the accountant give to these clients?
James J. Dewars has been the sole owner of a small CPA firm for the past 20 years. Now 52 years old, Dewars is concerned about the continuation of his practice after he retires. He would like to begin taking more time off now although he wants to remain active in the firm for at least another 8 to 10 years. He has worked hard over the decades to build up the practice so that he presently makes a profit of $180,000 annually.
Lewis Huffman has been working for Dewars for the past four years. He now earns a salary of $68,000 per year. He is a very dedicated employee who generally works 44 to 60 hours per week. In the past, Dewars has been in charge of the larger, more profitable audit clients whereas Huffman, with less experience, worked with the smaller clients. Both Dewars and Huffman do some tax work although that segment of the business has never been emphasized.
Sally Scriba has been employed for the past seven years with another CPA firm as a tax specialist. She has no auditing experience but has a great reputation in tax planning and preparation. She currently earns an annual salary of $80,000.
Dewars, Huffman, and Scriba are negotiating the creation of a new CPA firm as a partnership. Dewars plans to reduce his time in this firm although he will continue to work with many of the clients that he has served for the past two decades. Huffman will begin to take over some of the major audit jobs. Scriba will start to develop an extensive tax practice for the firm.
Because of the changes in the firm, the three potential partners anticipate earning a total net income in the first year of operations of between $130,000 and $260,000. Thereafter, they hope that profits will increase at the rate of 10 to 20 percent annually for the next five years or so.
How should this new partnership allocate its future net income among these partners?