Collins, Baker, and Lebo are partners in a business that distributes various electronic components used to control machinery in the printing industry. The partners have a lucrative business and have allocated profits according to the following agreement:
1. Salaries of $50,000 to each of the partners.
2. A bonus to Baker of 5% of sales to International Printers, Inc., in excess of $1,000,000.
3. A bonus to Collins of 10% of net income after this bonus.
4. Interest of 10% on each partner’s average annual invested capital in excess of $100,000.
5. Remaining profits to be allocated in the ratio of 5:3:2 for Collins, Baker, and Lebo, respectively.
In a typical year, the above agreement is applied under the following conditions: net income of $880,000; sales to International Printers, Inc., of $1,500,000; and average annual invested capital of $50,000, $120,000, and $250,000 for Collins, Baker, and Lebo, respectively.
Gordon, who is seeking to be admitted to the partnership, has approached the partners. Gordon has an exclusive licensing agreement with a manufacturer of control devices that can significantly reduce the amount of electricity used by machinery. Gordon is confident that these products will be extremely successful, but they lack an established customer base. Therefore, Gordon is most interested in pursuing discussions with the existing partnership. Gordon has proposed contributing $50,000 cash and the exclusive licensing agreement to the partnership in exchange for an interest in capital and profits. Furthermore, Gordon proposes that a new profit agreement be established with the following terms:
1. Salaries of $50,000 to each of the partners.
2. A bonus to Baker of 5% of sales to International Printers, Inc., in excess of $1,000,000 traceable to products not covered by the exclusive licensing agreement.
3. A bonus to Gordon of 15% of sales in excess of $2,000,000 traceable to those products covered by the exclusive licensing agreement. Gordon estimates that total sales associated with these products will be approximately $4,200,000.
4. Interest of 10% on each partner’s average annual invested capital in excess of $100,000.
5. Remaining profits to be allocated in the ratio of 3:3:2:2 for Collins, Baker, Lebo, and Gordon, respectively.
Collins is your personal tax client and comes to you for advice. Baker and Lebo are very excited about the Gordon proposal. However, Collins feels that Gordon may be unrealistic regarding the success of this new product line. Collins is concerned about giving Gordon a voice in the management of the partnership; but more importantly, she feels that her interest in profits may be less under the Gordon proposal. You understand your client’s concern and try to be positive by saying that the Gordon proposal may be worth it. Collins responds by saying, ‘‘Maybe it is worth it if I can make another $60,000 before taxes.’’
Required
Prepare a quantitative analysis that your client Collins may use to better assess the implications associated with the Gordon proposal.