In This Section |
Farm Business Partnerships
Table of Contents
IntroductionIn Ontario, just over 31% of farm businesses operate in some form of partnership arrangement. Many of these are family partnerships that have developed as children entered the farm business. Others are spousal partnerships and still others are formed by unrelated parties who see a business advantages to the partnership arrangement. This Factsheet will help farm business owners understand the partnership structure and decide if a partnership arrangement makes sense for their farm business. This Factsheet is one in a series covering business structures. Other Factsheets on farm business structures are:
Section 1 The Basics Of PartnershipsWhat Is A Partnership?The term "partnership" is not defined in the Income Tax Act, but generally refers to a relationship where 2 or more persons carry on a business with a view to make a profit. Over the years the courts have come to regard a number of factors as evidence that a partnership does exist. These are:
Co-ownership of property in and of itself does not create a partnership. Two people who own farmland together are not automatically considered to be in partnership. | Top of Page | Why Form A Partnership?Partnerships are formed for a variety of reasons, such as:
Other less formal business arrangements such as revenue sharing, joint ventures or paying wages to family members are often used prior to forming a partnership. The partnership structure is more formal and allows the partners to share in the growth of the business. Consider both the advantages and disadvantages before entering into a partnership arrangement. Advantages and Disadvantages of Partnerships, outlines some of these. Advantages and Disadvantages of PartnershipsAdvantages
Disadvantages
| Top of Page | How Is A Partnership Taxed?A partnership is not a separate legal entity like a sole proprietor or a corporation. As a result the partners report the net income of the partnership and their share is taxed in their hands. Partnership Financial StatementsA partnership must prepare an Income Statement for tax purposes. Although a balance sheet is not required it is highly recommended. Preparing a balance sheet each year will document how much each of the partners has contributed and withdrawn from the partnership, which is important in calculating the value of each partners interest. The value of each partners partnership interest is essential for an equitable dissolution of the partnership should that ever take place. A Partnership InterestThe equity or ownership that a partner has in a partnership is called a partnership interest. A partnership interest is considered capital, just as shares are or ownership of land is. It has a tax value called the adjusted cost base (ACB) and a fair market value. A partnership interest can increase in value resulting in a capital gain or lose value creating a loss. An interest in a family farm partnership in eligible for the $500,000 capital gain exemption. An individual who purchases a partnership interest cannot use any personal tax deductions for the underlying assets such as livestock, quota or equipment. These deductions are used by the partnership. If the purchaser uses debt capital to buy a partnership interest, the interest payments are an expense deducted on their personal tax return. It is not an expense of the farm business. If a partnership disposes of its assets instead of a partner selling an interest, the tax rules relating to each type of asset will apply. The funds flow through to the partner as either revenue or capital gain. The capital gain exemption of each partner can be used to offset any capital gain for assets that qualify. When Should You Form A Partnership?A partnership is often considered when the next generation wants to join the farming operation, spouses want to split income or siblings want to farm together. When is the appropriate time to move into a partnership arrangement? While there is no definitive answer, a partnership should not be formed until it meets the majority of the goals and needs of the partners. Some items to consider are listed below.
What Does It Cost To Form A Partnership?While it will vary according to the complexity of the business you can expect to pay between $2,000$3,500 to set up a partnership and about $500$1000 more for annual accounting fees than a sole proprietorship. Costs will include a provincial fee of $60 and professional fees for legal and tax advice. The annual accounting cost is usually somewhat higher because of the additional financial statements. However, if the farm already has full financial statements, the added annual cost may not be significant. Personal Preferences To Consider Before Forming A PartnershipA partnership structure may satisfy many of the criteria that the business has set, yet fail to match the familys goals and comfort level. Even if it is likely to help them reach their goals, the formality and increased complexity may be more than the family wants to accept. The business owners will want to ask themselves if they are comfortable with:
| Top of Page |
Section 2 Forming The PartnershipOwnership Of AssetsA partnership is a very flexible structure when it comes to the ownership of assets. The partners, the partnership, or a combination of both can own assets. The ownership of assets determines who claims the capital cost allowance, who makes loan payments and how assets are transferred. There is no ideal method of ownership, but whatever the ownership structure, clear documentation is important. Asset Ownership, shows the pros and cons of the different ownership options. Asset Ownership - Continuum of Asset OwnershipAssets owned by the partnersPros
Cons
Assets owned by the partners and the partnershipPros
Cons
Assets owned by the partnershipPros
Cons
| Top of Page |
Assets Owned by PartnersIn this style of partnership the partners own the assets. The partnership statements record only revenue and expense items. The capital assets are used by the partnership but are owned and financed by the individual partners. Capital cost allowance is claimed by the partners and not by the partnership. The partnership may own no more than a bank account and the market inventory. This type of partnership might be found in a spousal partnership where both spouses own the land and one spouse owns the production assets such as livestock, crops, supplies and equipment. Table 1, Partner Ownership, shows an example of how a parent-child partnership of this type would report income. In this example the parent has sold livestock to the child. The partnership splits net cash income prior to taking CCA. Each partner can deduct CCA from their share of net cash income if they chose to do so. Table 1. Partner Ownership
| Top of Page | Assets Owned by Partners and PartnershipIn this style of partnership both the partners and the partnership own the assets. It is sometimes referred to as a "modified partnership". For example the partnership could own current inventory items like livestock, crops, and supplies. The partners could own land and fixed equipment. Breeding livestock, quota and moveable equipment could be owned by either the partners or the partnership. It is not unusual for partners to own existing assets outside of the partnership while new purchases are owned by the partnership. Both the partnership and the partners will take capital cost allowance. This type of asset ownership is common in parent child and sibling partnerships as it can give a child a share of ownership in the productive assets. Table 2, Partners and Partnership Ownership, shows an example of how the partnership would deduct CCA and share income. Table 2. Partners and Partnership Ownership
Assets Owned by PartnershipIn this style of partnership all the assets are owned by the partnership. All the assets are rolled into the partnership. The partners only own a partnership interest. This interest can in whole or in part be transferred to a child. The capital cost allowance (CCA) is claimed by the partnership. Table 3, Partnership Ownership, shows how the income is shared. Note that the partnership deducts all of the capital cost allowance to determine net income. In this example the partnership income split is 60:40. Table 3. Partnership Ownership
This style of agreement is attractive to the family who like the simplicity of having all the assets owned by the partnership. It also is easier to prepare comprehensive financial statements for lenders. | Top of Page | Steps In Forming A PartnershipThere are any number of ways to complete the process of forming a partnership. The following steps are one way it might be completed. Regardless of the method used it is important that the process is clear to the partners, lenders and business advisors working with the family. In each of the steps below appropriate documentation would be required.
Partnership AgreementsWhile a partnership agreement is not required for a partnership to exist it is recommended. A properly drafted agreement establishes that a partnership is intended, clarifies the details of ownership and operation, and how disagreements between the partners will be resolved. Some items to include in a written partnership agreement are:
A partnership agreement usually contains rules governing the transfer of interests in the partnership, just as a shareholders' agreement governs the transfer of shares in a corporation. It is common for a partnership agreement to either prohibit altogether, or set forth rules to govern, the pledging or mortgaging by a partner of his partnership interest as security for his personal debts. They also often contain rights of first refusal and buy/sell provisions that limit a partner's freedom to sell his interest. Where a partnership agreement does not establish a fixed term for the duration of a general partnership, any partner may terminate the partnership at any time on giving notice of dissolution to all the other partners. Regardless of what the partnership agreement may provide, each partner is an agent of the firm and of his other partners for the purpose of conducting partnership business. The acts of a partner performed in the ordinary course of the firm's business bind the other partners. This causes all of the partners to be jointly and severally liable for all obligations and liabilities of the partnership. | Top of Page | Control of the partnershipIn a corporate structure the businesses ultimate control rests with the majority shareholder. It is less clear with partnerships. Usually the partnership agreement will state that the partners will endeavour to make decisions by mutual agreement. However if they cannot, the agreement will further state how the final decision will be reached. For instance the agreement might state what percentage of the vote certain partners have in the event that a mutual agreement cannot be reached. Spousal PartnershipsSpousal partnerships can be advantageous for splitting income and the capital gains of assets. A partnership arrangement may also more truly reflect the contribution of both spouses to the business. This can be important where equitable recognition is important to spousal partners from both a business and a personal perspective. Canada Customs and Revenue Agency (CCRA) look closely at the profit sharing arrangements of non-arms length partnerships (such as a husband and wife or children). If CCRA considers the allocation of income to be unreasonable it has the power to change it. CCRA will look at both the time expended and the expertise provided by a partner. Generally if a function performed by a partner does not require a specialized skill or training, it is expected the partners involvement will be on a regular basis and will require a significant amount of time to be spent in the partnership. However, if a partner has special skills, more value can be attributed to such time and less involvement would be acceptable. If one partner is not actively engaged in the business but contributes significant capital to the partnership, CCRA examines the source of the capital. For example, if one spouse makes the capital contribution from funds received by a gift or loan from the other spouse, CCRA might move to disallow income splitting with the non-active spouse. However, if the funds are loaned between spouses at reasonable interest rates, CCRA will not challenge contributions made by the non-active spouse. This fact re-enforces the importance of a spousal partnership agreement that clearly documents the partnership. The division of profits must also be reasonable (see Section 3 Allocation of Income to Partners). Are You Operating As A Spousal Partnership Right Now?In some cases spouses may wish to clarify if they are currently considered a partnership. If the answer to the following questions is yes, then a spousal partnership likely exists.
In some cases it can be argued that a spousal partnership already exists and has since marriage. In such a case no rollovers would be required, just a declaration of the facts as a preamble to the partnership agreement. A written spousal partnership agreement is highly recommended. While an agreement alone, without the supporting facts does not make a partnership, it does indicate the position the spouses have taken in establishing their partnership arrangement. Claiming CCA A Potential TrapIt is important not to claim capital cost allowance (CCA) at the partnership level if you want to demonstrate that you own the assets personally. If CCA is taken at the partnership level Canada Customs and Revenue Agency (CCRA) could interpret this that the assets have been transferred to the partnership. If the proper election forms have not been filed CCRA could view that as a fair market value sale to the partnership and require taxes paid on any capital gains, income or recapture. This problem is more likely to occur in spousal partnerships where no assets have been transferred and the need for filing forms does not seem as important. | Top of Page | Tax Implications Of Forming A PartnershipThe following is a brief introduction to some of the tax implications of forming a partnership. This is intended as information only. Tax advice from an accountant familiar with farm partnerships is recommended. Rollover of Assets Into a PartnershipThe Income Tax Act allows for the transfer of assets into a Canadian partnership on a tax-deferred basis. This is called a rollover. Under normal rules any transfer would take place at fair market value (FMV). The rollover allows you to choose any value between the adjusted cost base (ACB) and FMV. In order to take advantage of this rollover an election must be filed at the time of the transfer. It is recommended that the election be used at all times. This is because it would prevent tax in the case of an incorrect inventory valuation or in the case where CCRA might dispute the calculation of a FMV figure for real estate and substitute a higher figure. A proprietor may roll assets into a partnership at a value that triggers no tax or at a value that triggers enough income to use up previous losses. If the partner is only receiving a partnership interest as consideration for their assets they can elect at any value they choose. However, if the partnership is paying for part of the value of the asset by assuming the partner's debt or by owing an amount to the partner, the elected value cannot be less than the consideration received. This higher value may then trigger some tax. This would often be true in cases where a significant amount of debt is assumed by the partnership. The following scenarios outline 3 different methods of establishing a partnership where parents and a child want to farm together in a partnership arrangement. These scenarios show various asset ownership styles and how assets would be transferred to form the partnership. The tables show the beginning position of each partner, the action taken with each asset and the final position after the partnership has been formed. A more detailed version of these tables, with the complete tax values included can be found in Appendix 1. Scenario 1In this example the assets are owned personally by the partners. In order to establish an equal 3-way partnership each of the partners put in $5,000 cash. The father sells one half of the quota, machinery and inventory to the child for $225,000. The father holds a note as evidence of the debt. The result is a 1/3-1/3-1/3 partnership as shown in Table 4, Scenario 1 Forming a Partnership. Table 10 in the appendix contains the tax details. Table 4. Scenario 1 Forming a Partnership
| Top of Page |
| Top of Page |
Scenario 2In this scenario the assets are owned by both the partners and the partnership.
As in scenario 1 each of the partners contributes $5,000 cash. However
the father does not sell any assets to the child but rather transfers
them directly to the partnership. The result is the partnership ownership
is heavily weighted to the father. In this case the child might supply
a larger portion of the labour and therefore receive a greater share of
profits than the 0.5% indicated by capital contributions alone. The partnership
is shown in Table 5. Scenario 2 Forming a Partnership
| Top of Page |
| Top of Page |
| Top of Page | Scenario 3Here the assets are owned by both the partners and the partnership. In this case the father sells his 1/2 share in the quota to the child and also transfers some other assets to the partnership. The child then transfers the newly acquired quota to the partnership. This creates a partnership where the child has the largest share of the partnership, while the parents still own a significant amount of the assets. The partnership is shown in Table 6, Scenario 3 Forming a Partnership. Table 12 in the appendix contains the tax details. Table 6. Scenario 3 Forming a Partnership
| Top of Page |
| Top of Page |
| Top of Page | Section 3 Operating The PartnershipAllocation Of Income To The PartnersThe method of allocating income to the partners is usually outlined in the partnership agreement. In some cases, it will be a straightforward calculation such as an equal share allotted to each partner. In other instances, the allocation might be more complex. For example, if one partner provides all the labour, and the other partner is not active in the partnership on a daily basis, the partners may agree the active partner should receive, for example, the first $25,000 of income. Both partners would share all remaining profits equally. This demonstrates that allocation of income does not need to follow the ownership structure. This extra allocation is often referred to as a wage, but in fact, partnerships cannot deduct wages to partners. It is simply an allocation of income and no wage deductions are required. Calculating A Profit ShareNet income from a partnership should be shared by the partners in a reasonable manner. If the partners are related, Canada Customs and Revenue Agency can change the allocation of income if it deems is unreasonable. Drawings and SalariesThis can be a confusing area, especially in relation to how taxable income is calculated. The important point to remember is that the partnership allocation of income determines the taxable income of the partners and not the drawings that they choose to take. What the partners report from year to year will change as the profitability of the partnership changes or if the allocation formula is changed. The drawings on the other hand might stay the same from year to year. Table 7, Allocation of Income and Drawings, shows and example of 3 partners, each taking drawings from a partnership. The partnership split is 40-40-20. In the example the drawings each year stay the same but the income of the partnership drops in the 2nd year. Note that in year 1 the partners report more for tax than they actually drew. This means that the value of their partnership interest increased. In year 2 the opposite happens. Partners A and B reported less for tax than they drew out of the partnership and their partnership interest decreased in value. Partner Cs drawings were the same as what was reported for tax. Money left in the partnership (when drawings are less than the allocation) can be used for financing operations, loan repayments or capital purchases. In the example in Table 9 note that at the end of year 1 the partnership had $5,000 remaining in the partnership. This was income generated by the partnership but not drawn out by the partners. That drops to $0 at the end of year 2 because partners A and B drew out more money than the partnership made or allocated that year. Table 7. Allocation of Income and Drawings
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||