Distribution of Profit Among Partners: Journal Entry, Rules & More

Download PDF 📄

Profit sharing among partners is one of the key aspects of a partnership firm. It refers to how the profits earned by a business venture are divided among the partners on a predetermined ratio. Such a ratio is agreed upon at the time of the partnership agreement, though it can be altered if all partners agree on it. The distribution can be based on the capital invested by each partner, their efforts, or any other agreed-upon basis. Knowing how profits are divided is essential to have a transparent and fair partnership, which maintains healthy business relationships.

How is Profit Divided Among Partners in a Firm?

The profit sharing among the partners of a firm depends primarily on the partnership agreement. Normally, the said agreement indicates how the profit or loss is to be distributed between the partners. The method of distribution can be dependent on several parameters such as capital contribution, time devoted to the business, and the skills brought in by the respective partners.

Factors Influencing the Distribution of Profit

Capital Contribution: This is the most common method and is usually a distribution of profit according to the capital brought in by each partner. For example, if one partner has more capital than another, then that person will take a bigger share of the profit. The agreement will be made with how much capital is required from each partner and the percentage of profit.
Equal Division: All partners agree to share profits equally at times. It is an attractive plan where all the partners invest an equal amount of time, effort, and expertise, albeit different capital investments in the firm.
Based on Effort or Expertise: In some instances, profits are divided according to the input of each partner in terms of time, effort, or expertise. A partner who spends more time running the business or has specialized skills might receive a higher share of the profits, even if their financial contribution is smaller.
Profit Sharing Ratio: The profit sharing ratio is decided amongst the partners and must be stated in the partnership deed. It can be dynamic and can be amended anytime in mutual agreement amongst the partners. For instance, if a partner is bringing on more numbers of clients or is taking a risk, he may demand a more significant share of profit.
Salary to Partners: In some companies, partners may receive a fixed salary in addition to their share of profits. This salary compensates them for their time and effort. The profit after salary distribution is then divided among the partners as per the agreed-upon ratio.

Example of Profit Division

Consider a partnership firm where Partner A contributes 60% of the capital and Partner B contributes 40%. In this case, the distribution of profit among partners could follow the capital ratio. So, if the firm earns a profit of $100,000, Partner A would receive $60,000 and Partner B would receive $40,000. However, this ratio can be adjusted if they agree to base it on effort or other factors.

Journal Entry for Distribution of Profit Among Partners

When profit distribution among partners is done, it is quite important that the transaction should be recorded with accuracy in the company’s books of account. This is to ensure all financial transactions are transparent, and each share of the profit of a partner is accurately documented. Now, let us see how the journal entry of profit distribution is made in the books of the firm.

Journal entries for the distribution of profit amongst partners in a partnership firm mostly involve two main accounts- The profit and Loss Account, and the Capital Account, or the Partner’s Current Account. The Profit and Loss Account gets closed at the end of the accounting period, while all the profits realized are distributed according to the agreed profit-sharing ratio to the capital or current accounts of the individual partners.

Journal Entry for Profit Distribution:
- Debit: Profit and Loss Account (for the total profit)
- Credit: Partner’s Capital or Current Account (based on their profit share)

For example, if the total profit is $100,000 and the profit-sharing ratio is 60:40 for Partners A and B respectively, the journal entry will look like this:

Account	Debit	Credit
Profit and Loss Account	100,000
Partner A’s Capital Account		60,000
Partner B’s Capital Account		40,000

If Partners Receive Salaries: If a partner receives a salary, this salary is also recorded as an expense before the distribution of the remaining profit. The journal entry for salaries would be:
- Debit: Salary Expense Account
- Credit: Partner’s Current Account

Distribution of Profit Among Partners in Private Limited Company

The distribution of profit among partners is handled differently in a private limited company compared to a partnership firm. The profit share among the partners is directly provided to them in a partnership, but in a private limited company, the profits are distributed to the shareholders. We will assume that the company has partnerships or multiple partners who own the firm for this section.

Profit Sharing in Private Limited Company

In a private limited company, the profit is usually distributed among the partners or shareholders in the form of dividends. A shareholder gets dividends based on the number of shares held, and such dividends are paid from profits after taxes.

The process for profit distribution in a private limited company works as follows:

Determination of Net Profit: The firm calculates its net profit after deducting all expenses, taxes, and other deductions.
Retention of Earnings: A part of the profits may be retained in the firm for reinvestment or growth. It is done in the form of retained earnings.
Declare Dividends: The management of the company declares the amount of dividends to be issued to the shareholders after having decided on the retained earnings. The amount each shareholder gets is proportional to the number of shares he holds.
Dividend Distribution: The dividends are distributed to the shareholders, which can either be paid in cash or in additional shares. It is usually done after getting approval from the board and attracts tax as well.

Distribution of Profit Among Partners Income Tax

The distribution of profit among partners has an important bearing on income tax. Each partner is taxed separately on the share of profit he receives, and one needs to understand the implications of these distributions on the tax responsibility of the business and its partners.

Taxation of Profits in a Partnership

In a partnership firm, profits are not taxed at the entity level. Instead, each partner is responsible for paying taxes on their share of the profit. The tax rate depends on the individual’s income bracket.

Income Tax for Partners: Individual tax returns of the partners will carry their shares of the income. The tax is collected based on the personal income tax rates applicable to the partner.
No Tax at Firm Level: Unlike corporations, there is no corporate income tax on profits for a partnership. That is because the partnership is a pass-through entity for tax purposes. The profits are “passed through” to the individual partners who then report the same on their personal tax returns.
Advance Tax: If a partner has significant income from the partnership, he would pay advance tax throughout the year.

Partnership Distribution Rules

The profit sharing among partners is subject to certain rules, usually stipulated in the partnership agreement. These rules set out how profits and losses shall be shared among the partners. If the agreement does not specify such terms, then the default rules under the Partnership Act of 1932 apply.

Default Distribution Rules

Equal Profit Sharing: If no specific profit-sharing ratio is mentioned in the partnership agreement, the default rule under the Partnership Act is that profits and losses will be shared equally among the partners.
Capital Contribution Basis: If the partnership agreement specifies that profits will be shared based on capital contribution, the distribution will be proportional to the amount each partner has invested in the business.
Effort or Expertise: In some cases, the distribution may also be based on the amount of work or expertise each partner brings to the business. If one partner contributes more time or effort, they may be entitled to a larger share of the profits.
Loss Sharing: The rules for sharing losses are typically the same as those for profits, but this should also be clarified in the partnership agreement to avoid misunderstandings.

Distribution of Profit Among Partners FAQs

What is the basis for the distribution of profit among partners?

The distribution of profit among partners is based on factors like capital contribution, the time invested, and the agreed profit-sharing ratio. The partnership agreement outlines these terms to ensure fairness and transparency.

How is profit shared in a private limited company?

In a private limited company, profits are typically distributed to shareholders as dividends. The amount each shareholder receives is proportional to the number of shares they own in the company.

Is the profit distribution subject to income tax?

Yes, the distribution of profit among partners is subject to income tax. Partners must report their share of the profits on their personal income tax returns, and the profits are taxed based on individual tax brackets.

How do partners declare their share of profit?

Partners declare their share of profit in their income tax returns. The profits are reported as part of their total income, and they are taxed according to their income tax rate.

What are the default profit-sharing rules for partnerships?

If no specific profit-sharing ratio is mentioned in the partnership agreement, the default rule under the Partnership Act is that profits and losses are shared equally among the partners.