In our last article we discussed the importance of registering a partnership and establishing a sound partnership agreement between the partners.
Without the latter, the Canada Revenue Agency has the ability to establish the portion of income generated as being equal among partners when that may not be the intention of the partners.
Key components of a partnership agreement should identify:
The partner’s initial contribution (buy-in) into the partnership
This may be in the form of cash, investments and/or assets. If the partner chooses to roll assets into the partnership, this may be accomplished by a tax-free rollover at cost.
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Some partners may choose to be less active than others so this should be addressed in the agreement. Therefore, the agreement should include the expected individual contribution of each partner, including expected time and effort supplied by each.
Agreed upon distribution of income and expenses
- An initial sum, or salary, for those partners who are active in the partnership relative to those partners who are not active.
- Interest on capital
- Partner’s interest and the percentage of residual income (percentage of profit or loss incurred after salary and interest on capital is paid out)
Termination or departure from the partnership
- This may include voluntary or involuntary departures and death.
- The conditions under which and process involving the addition of a new partner.
- The conditions that would trigger the sale or dissolution of the partnership.
In general, most partnership agreements will look after partners that invest their time and effort first and then provide partners who contribute capital as the second tier of payment (only if there are profits to share). Finally, if there is residual income after the salary and capital components are paid out, the partners will share the balance.
CRA treats each income allocation as such. Most income from an active business remains as active business income to the partners receiving the allocation.
Note that all income maintains its own characteristics. For example, dividends received by the partnership are dividends that are declared by the partners.
Charitable donations of the partnership are allocated as charitable donations to the partners.
For tax purposes, each partner carries on the business of the partnership regardless of whether they are silent or inactive partners, as long as they are not considered “limited partners” under the Income Tax Act.
The tax benefits of sharing in-come through this business model are usually bullet proof in the eyes of CRA as long as the agreements are set up well in advance of the partnership operation as it supports the business reason for establishing the income allocations rather than setting up the allocations for tax purposes only.
Tax preferred allocations may be subject to CRA reallocations if considered merely to reduce tax. This is especially true in a non-arm’s length partnership.
When preparing a partnership agreement it is always prudent to involve your tax and legal professional.
Grant Diamond is a tax analyst in Saskatoon, SK., with FBC, a company that specializes in farm tax. Contact: fbc@fbc.ca or 800-265-1002.
