A business partnership agreement should recognize that people come and go in our lives and businesses. It should be drafted in a way that accommodates change so as to avoid problems later on.
A partner might want to leave, so the agreement should anticipate how to buy out that person’s interest.
The partners might want to welcome a new person. How does that person buy in?
And a partner might die. How does the deceased ownership interest pass to the estate, and how is it taxed?
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Adding a new partner
Under law, all partners must agree to the admission of a new partner unless the partnership agreement permits otherwise.
As well, if there are no specific instructions in an agreement, it is assumed that new partners will have the same rights and obligations of existing partners.
Care should be taken to ensure that the addition of the new partner does not create a new partnership or dissolve the existing one.
In particular, the agreement should specify the required contribution, participation rights, liability before and after admission and management role of the new partner. A firm integration plan needs to be outlined.
There are two ways a new partner may be admitted to a partnership:
- The new partner acquires the interest from one or more partners.
- The new partner acquires interest by contributing capital to the partnership.
In the former method, a new partner acquires his interest from one or more partners. Those partners will be deemed to have disposed of a portion of their interest for proceeds equal to the consideration received from the new partner. A capital gain or loss may result.
In the latter method, the acquisition cost, which is assumed to be at fair market value, is now the partner’s adjusted cost base.
The other partners are not deemed to have disposed of a portion of their interest. As a result, no tax consequences is associated with the existing partners.
Death or disability
What happens if the partnership is automatically dissolved?
Without a partnership agreement, rights do not transfer to successors, heirs or executors when a partner dies because the relationship is specific to the partnership.
However, the partners can use an agreement to stipulate that death or disability does not dissolve the obligations of the remaining partners and the rights of the withdrawing partners.
Deemed disposition
From a tax perspective, the death of a partner usually results in the deemed disposition of his partnership interest on the date of death, and the estate then represents the partner until the partnership interest is settled.
The partnership agreement usually addresses the immediate sale to the existing surviving partners or the admission of a replacement partner, such as a spouse or child.
Many farm partnerships, which may only include the spouses, create a scenario where the surviving spouse is now the only member of the partnership.
Unless a child or another individual replaces the spouse that has died, the partnership automatically dissolves and we have dispositions of partnership interests for both spouses. The partnership assets are now those of the surviving spouse.
The assets transfer at cost, except for the capital gain-loss on the disposition of the partnership interests. There are no tax consequences.
The partnership is deemed to continue if children replace the deceased.
A professionally prepared partnership agreement will address these scenarios, so it is always prudent to involve tax and legal professionals when preparing such an agreement.
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.
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