A partnership firm is one of the forms of business entity. A clause related to distribution of profits or losses shall be incorporated in the partnership deed at the time of creation of partnership firm in order to avoid any conflicts that may arise between the partners in future. Partners may by mutual consent decide to share profits on the basis of their capital contribution in the firm or may agree on a particular profit sharing ratio.
Even though a written agreement between the partners is not required to run a partnership firm, it is advisable to create a partnership deed with specific clauses on profit or loss distribution. It is important to note that profits are available for distribution at the end of the year after all incomes and expenses have been accounted for in the firm’s books of accounts. Any partner should not make a claim for his/her share of profits on a monthly basis.
Profit Sharing On The Basis Of Capital Contribution Made By Partners
All partners contribute some amount of capital in the partnership firm. This amount can be used as a basis for distribution of profits at the end of the year. For Instance, A and B are partners in a partnership firm. A contributes $ 75,000 and B contributes $ 25,000 as capital in the firm. The firm has earned profits of $ 1, 20,000 at the end of the year. In order to calculate the share of profits to be received by A and B, we will first calculate the ratio of their capital contributions.
Since, A has contributed $ 75,000 and B has contributed $ 25,000, the ratio of their capital contributions would be 75:25. As a result, A would be entitled to receive 75% of the profits and B would be entitled to receive 25% of the profits. Since profit earned by the firm is $ 1, 20,000, A will be entitled to receive $ 90,000 (1, 20,000*.75) while B will get $ 30,000 (1, 20,000*.25) as his/her share in profits.
Profit Sharing Ratio
Any profits earned by a partnership firm may also be distributed on the basis of profit sharing ratio as mutually agreed between the partners. This ratio can be expressed in terms of a percentage or in a proportion. Depending on the agreement between the partners , profit sharing ratio can be expressed as 60% and 40% or 60:40 or even as 6:4. It is to be noted that where there are more than two partners, profit sharing ratio can be expressed as 1:1:1, 60:20:20 and so on.
Let us take an example to illustrate the division of profits among partners on the basis of profit sharing ratio. For Instance, X, Y and Z are three partners in a partnership firm. A profit sharing ratio of 70:20:10 has been agreed between the partners. X is entitled to receive 70% share in profits, Y is entitled to receive 20% share in profits and Z is entitled to receive 10% share in profits.
If the amount of profit at end of the year is $ 90,000, X will be entitled to receive an amount of $ 63,000 (90,000*.70), Y will be entitled to receive a share of $ 18,000 (90,000*.20) and Z will be receive $ 9,000 (90,000*.10) as his/her share of profits.