Legal Forms for Canadian Businesses -Partnership Distribution Timing Trap
The Canadian legal environment provides businesses with a number of different choices for legal forms to structure themselves, most prominently corporations, sole proprietorships, partnerships and limited partnerships. These forms have different legal and tax aspects associated with them. Partnerships are a useful business form with significant tax advantages, but also some unexpected traps for unwary taxpayers. This article briefly summarizes the tax aspects of partnerships in the Canadian legal landscape and describes particular partnership tax traps that our experienced Toronto tax lawyers make sure our clients avoid.
If an individual begins carrying on a business by themselves without setting up different legal form for the business, then the individual will be operating a sole proprietorship. In this legal form, there is no concept of a business entity separate from the individual. The individual will be fully liable for all liabilities incurred in the course of carrying on business. The individual will need to report the profits of the business as his or her own business income on his or her income tax return and is also able to claim the losses of the business as his or her own.
Corporations are the most familiar business form for most Canadians. Corporations are treated as a separate legal person from their shareholders (i.e. the persons who own a corporation). One consequence of this is that except in special circumstances creditors of a corporation can only access the assets of the corporation and not the assets of its shareholders. From a Canadian income tax perspective, corporations are treated as independent taxpayers responsible for paying tax on their own income separate from their shareholders.
A partnership is a relationship which exists between a group of persons carrying on a business together with a view to profit. The partners are personally liable for the debts of the partnership. Canadian income tax law does not treat partnerships as taxpayers liable to pay tax on the income generated by the business of the partnership. Instead, every partnership has a fiscal period (usually one year in length). The income or loss earned by the partnership during that fiscal period is allocated to its partners in proportion to their ownership of the partnership as laid out in the partnership agreement. Each partner then includes their portion of the income or loss from the partnership in their tax year in which the partnership's fiscal period ends. This income tax feature of partnerships can be very useful for businesses which are expected to operate at a loss for an extended period of time before becoming profitable as this allows the partners to shelter their income from other sources using the partnership's losses.
A limited partnership is a type of partnership that includes at least one general partner and at least one limited partner. A general partner is any partner who is not a limited partner. General partners operate as described in the preceding section. A limited partner is not permitted to take an active role in running the partnership's business but is also not liable to creditors of the partnership other than for the limited partner's investment into the limited partnership. This business form is useful when the partnership tax treatment is desirable and some investors in the business will provide funding but not be involved in operating the business. In most circumstances limited partners receive the same tax treatment as general partners, however as described below, there are some circumstances in which they are treated differently which can give rise to tax traps.
Partnership Adjusted Cost Base -Partnership Distribution Timing Trap
The interest that a partner (or limited partner) holds in a partnership or limited partnership is property that can be disposed of by the partner for a gain or loss. This article is focused on the cases where a taxpayer's partnership is capital property (i.e. the taxpayer is not in the business of buying and selling partnership interests). When a taxpayer disposes of capital property, the taxpayer's gain or losses is equal to the taxpayer's proceeds of disposition minus the taxpayer's adjusted cost base. The taxpayer's proceeds of distribution are what the taxpayer receives in exchange for giving up the partnership interest. For example, this could be the sale price of the partnership interest or the taxpayer's share of the partnership's assets when the partnership dissolves. The starting point for calculating a taxpayer's adjusted cost base for a partnership interest is how much it cost the taxpayer to acquire the interest in the partnership. This could be the amount invested in the partnership or the cost of purchasing a partnership interest from an existing partner. The taxpayer's adjusted cost base may also be subject to a variety of upward or downward adjustments applicable to specific circumstances.
A taxpayer's adjusted cost base of an interest in a partnership is subject to the following specific adjustments by virtue of being an interest in a partnership:
- upwards by the amount of the taxpayer's share of the partnership's profits for each fiscal period of the partnership,
- upwards by the amount of any capital contribution made by the taxpayer to the partnership (not including loans to the partnership),
- downwards by the amount of the taxpayer's share of the partnership's losses for each fiscal period of the partnership, and
- downwards by each distribution of the amount of the taxpayer's share of the partnership's profits or capital.
These adjustments are necessary to prevent either double taxation (i.e. where partnership profits are taxed both as business income and as a capital gain) or non-taxation of partnership profits. Importantly, the adjustments based on the allocation of the partnership's profits or losses for a fiscal period only take place at the start of the next fiscal period. The adjustments for capital contributions or distributions will effect the adjusted cost base of the partnership at the time of the contribution or distribution.
Negative Adjusted Cost Base -Partnership Distribution Timing Trap
It is possible that the types of downward adjustments discussed above can result in a taxpayer's adjusted cost base for a partnership interest to be reduced below zero. Normally, when the adjusted cost base of capital property becomes negative, there is a deemed disposition and the adjusted cost base of the capital property becomes zero. The taxpayer's gain from the deemed disposition is the sum of all the downward adjustments to the taxpayer's adjusted cost base minus the sum of the cost of the property and all of the upward adjustments to the taxpayer's adjusted cost base (i.e. exactly enough to move the adjusted cost base up to zero).
Interests in partnerships are generally exempt from this deemed disposition rule and can hold a negative adjusted cost base indefinitely until another type of disposition occurs. However, specified members of a partnership and limited partners are still subject to the deemed disposition. For a particular fiscal period of a partnership, a partner is a specified member if they were a limited partner at any point in the fiscal period or if the partner was not actively engaged in the business of the partnership or carrying on a similar business as that engaged in by the partnership on a regular, continuous and substantial basis throughout the part of the year the business of the partnership is ordinarily carried on and during which the partner was a member of the partnership. Engagement in the financing of the partnership's business does not count as being actively engaged in the business of the partnership for the purposes of determining specified member status.
The Adjusted Cost Base Timing Trap -Partnership Profit Distribution Timing Trap
The timing of the adjustments to the adjusted cost base of partnership interests can lead to unexpected and undesirable deemed dispositions for limited partners and specified members. If a partnership distributes any profits or capital to its partners during the fiscal period, that will lower the adjusted cost base of the partners immediately. The upward adjustment for the partnership's profits from the fiscal period only takes effect at the start of the next fiscal period. That means that distributing funds to the partners can cause the specified members' adjusted cost bases to dip below zero and trigger capital gains notwithstanding that the profits for the present fiscal period could be large enough to offset the distribution. This would result in limited partners or specified members paying tax on an unnecessary capital gain and still paying tax on the income inclusion for the profits for the partnership's fiscal period.
Pro Tax Tips - Partnership Distribution Timing Trap
The trap discussed above can be avoided with appropriate advice and tax planning from an experienced Toronto tax lawyer. In instances where it is important that limited partners and specified members still receive funds from the partnership during the relevant fiscal period it may be possible to circumvent the above tax trap by having the partnership lend funds to the limited partners and specified members instead of making a distribution. Then in the next fiscal period the partnership can make a distribution to those partners of promissory notes that can be offset against the loans. Expert tax planning is required in advance of implementing this type of strategy to ensure that no anti-avoidance rules are violated. In order to have this type of strategy hold up in the eyes of tax authorities it is also necessary to ensure that the loans and distributions are documented properly.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.