The Problem of Contributions of Labor in Partnership
What happens where A is entitled to 50% of the profits as compensation for her labor, and B to 50% for his contribution of cash, but there are only losses?
It seems likely that parties expected that A's labor was worth same as B's cash.
In that case, they might have thought about it like this:
Time 1: When the firm is organized.
A -- Capital account = $50,000, in kind
B -- Capital account = $50,000, in cashTotal partnership value: $100,000 ($50,000 in cash, $50,000 in expected labor contribution).
Time 2: When the firm is terminated.
Partnership has lost $10,000. Now, it has $40,000 in cash.
-- If the firm were to continue, the $10,000 loss would be allocated equally between the parties (losses follow profits).
-- If the parties decide to wind-up and terminate, they may discover that the firm has no value beyond the $40,000 cash-on-hand. Who gets it?
I. Greenwood's Rule.
Using the capital accounts above, the firm has a loss of $60,000, not $10,000. Losses follow profits, so each partner is credited with $30,000 loss, and each partner has a $20,000 capital account. The $40,000 final residual value is divided evenly.
A: $50,000-$30,000=$20,000
B: $50,000-$30,000=$20,000
I know of no court that has reached this solution based on the default rules of the statute, but, of course, it is easy to put into the Partnership Agreement.
II. The Majority Rule.
The majority rule assumes that the initial capital accounts were:
A: $0
B: $50,000Total: $50,000
When the firm is wound up and terminated, $40,000 remains, so there is a $10,000 loss. Losses follow profits, so this is allocated equally among the partners. Therefore, the final capital accounts are:
A: $0 - $5000 = ($5000)
B: $50,000 - $5000 = $45,000Total: $40,000
This means: A has to put in an additional $5000. B gets the firm's $40,000 and an additional $5000 from A. A is out not only a year's work but $5000 cash as well.
II. The California Rule.
California and some other states see the majority rule as unfair, and rule that a labor-only partner doesn't have to put up additional cash. Thus, A gets nothing for a year's labor, and B receives back $40,000 of his original $50,000 investment. This rule doesn't seem to fit any understanding of the capital accounts.