CHAPTER FIFTEEN

1. CHAPTER FIFTEEN • Partnerships • I.The Standard Partnership – Definition and Format • II. Taxation of Partnership Operations • III. Partnership Structure – Impact on Decision Making

2. I. The Standard Partnership – Definition and Format • A partnership is the relationship that exists between entities carrying on a business in common with a view to profit. • A partnership venture consists of the partnership entity, which conducts its affairs as a separate organization, and a particular number of partners.

3. Partnership Agreement • A partnership is created by the execution of a partnership agreement between the various partners. • The partnership agreement outlines: • Each partner’s required contributions to the entity. • The format and rules for decision making and the management of the partnership’s business affairs. • How profits or losses are to be shared by the participating partners.

4. Partner’s Contribution • A partner can participate in a partnership venture by contributing capital or effort or a combination of the two. • Financial resources contributed can include cash and specific assets such as land, buildings, equipment, patents, and franchises. • The cash or the value of the specific assets contributed constitutes the partnership’s equity base.

5. Management • Usually all partners participate in the management of the enterprise, although by agreement specific partners may be excluded from this process, in which case they are entitled only to share in the operating results. • A special aspect of standard partnerships is that the procedures for decision making can be tailored to the wishes of the participating partners. • Management decision making within a partnership is completely flexible and can be as democratic or as autocratic as the partners wish.

6. Sharing of Operating Results • Profits or losses are usually shared as a function of capital contributions, or the degree of effort or participation in the business process, or both. • The sharing of profits and losses is a function of the partnership agreement.

7. Partner Liability • The standard partnership is a separate functioning entity for management purposes. • However, it is not a protected legal entity that is separate from the affairs of the partners. • All obligations and debts incurred by the partnership or by partners acting in the course of partnership business, and all negligent activities performed by them, are the full responsibility of each partner participating in the venture. • Each partner is jointly and severally liable for all partnership activities.

8. II. Taxation of Partnership Operations • A partnership is not a taxable entity and bears no responsibility for tax on income generated within its sphere of operations. • Instead, income earned or losses incurred by the partnership are allocated to the partners, in accordance with the agreed sharing ratio, for inclusion in each partner’s income for tax purposes. • The income shared by the partners is allocated for tax purposes regardless of whether such profits have actually been distributed to the partners.

9. The amount of income earned or losses incurred by the partnership is determined for allocation as if the partnership were a separate taxable entity. • The partnership can earn business income, property income, and capital gains; all of these are determined according to the normal rules for arriving at income for tax purposes. • All partnership income allocated retains its source and characteristics when included in the partner’s income.

10. The Partnership Interest • A partner is considered to own a partnership interest whenever that partner has rights and obligations created by being party to a partnership agreement. • The partnership interest is a tradeable asset that can be bought and sold much like a share of a corporation’s capital stock. • In most circumstances a partnership interest is treated as capital property for tax purposes; as such its disposition results in a capital gain or loss.

11. Usually a partnership is created when the participants contribute capital in the form of cash or assets in return for a partnership interest. • Thereafter, an unrelated entity can become a partner by: • Purchasing a departing partner’s interest, or acquiring a portion of the interest of each remaining partner; or, • Contributing cash or specific assets directly to the partnership in return for a new partnership interest.

12. Existing partners can depart or diminish their percentage of participation by • Selling all or a portion of their partnership interest to a new partner or existing partner(s); or, • Withdrawing their capital directly from the partnership treasury.

13. An important feature of partnerships is that any change in value of the partnership interest resulting from profits retained or losses incurred does not create a capital gain or capital loss when the partnership interest is disposed of. • Capital gains or losses on the sale of a partnership interest occur only to the extent that the individual assets owned by the partnership have changed in value. • This results from an arbitrary adjustment to the cost base, for tax purposes, of the partnership interest.

14. Transactions with Partners and Reorganizations • A partnership is considered to be a separate entity for purposes of holding assets. • If partners buy property from the partnership, or sell it to the partnership, those transactions are automatically considered to have taken place at FMV. • As an alternative, a partner can choose, by election, to transfer property into a partnership at a value equal to the partner’s cost for tax purposes. • When an existing partnership transfers its assets to a partner, those assets are considered to have been sold at FMV.

15. The choice of a partnership form of organization is not binding on the participants. • An existing partnership can be converted into a corporation in which the former partners are shareholders. • While the transfer of partnership assets to a new corporation is subject to the FMV rules, a partnership can elect to convert itself into a corporation without immediate tax consequences.

16. Small Business Deduction and Private Corporate Partners • If a CCPC is a partner in a partnership activity, it is entitled to use the SBD on the active business income earned by the partnership and allocated to it. • However, the active business income earned by the partnership that is eligible for the SBD is limited to $300,000 annually.

17. III. Partnership Structure – Impact on Decision Making • When a choice of business structure is being made, the standard partnership entity cannot be analyzed in isolation; instead, it must be considered in relation to other possible structures. • The main alternative to the partnership is the separate corporation, the shares of which are held by the participating entities.

18. Whenever an entity is considering participating in a venture with other parties, it must consider these four fundamental tax issues: • What will be the tax cost on the annual operating profits generated from the new venture? • If operating losses are expected during the start-up phase, how and when can such losses be utilized against other sources of income of the venture itself or of the participating parties? • What will the tax implications be if the venture fails and is either terminated or sold off at a loss? • How will the capital invested and the accumulated profits be returned to the investor?