Farm Business Partnerships

Agdex#:	812
Publication Date:	September 2002
Order#:	02-047
Last Reviewed:	August 2008
History:	Original Factsheet
Written by:	Rob Gamble - Finance and Business Structures Program Lead/OMAFRA

Table of Contents

1. Introduction
2. Section 1 — Basics of Partnerships
3. Section 2 — Forming a Partnership
4. Section 3 — Operating the Partnership
5. Section 4 — Transferring the Partnership to the Next Generation
6. Section 5 — Dissolving the Partnership
7. Appendix 1 — Detailed Tax Calculations

Introduction

In 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:

• Farm Corporations, Order No. 01-057
• New Generation Co-operatives, Order No. 02-017

Section 1 — The Basics Of Partnerships

What 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:

• the existence of an agreement to share the profits and losses of a business
• the ability of each partner to contractually bind the other partners
• joint ownership of property (although it is common to hold some property outside of the partnership)
• the use of the words "partner" and "partnership" in any written documentation (i.e., how the relationship is perceived by third parties)
• the use of a partnership name, joint bank account, joint accounting and financing, etc.
• formal registration as a partnership.

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.

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Why Form A Partnership?

Partnerships are formed for a variety of reasons, such as:

• spouses who want to split income and reduce taxes
• bringing family members into the business either to allow a child gain experience or to transfer a portion of the business
• unrelated parties that want to better utilize and reduce the cost of capital assets.

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 Partnerships

Advantages

• Flexibility — With proper documentation and agreements, a partnership structure can be adapted to any family situation to allow for income splitting between spouses, between parents and children, between siblings or between non related parties.
• Allows intergenerational transfer of the business — The child can ease into the business, operate it jointly and then allow the parents to ease out. Sharing of responsibility and profits is possible. All tax deferral opportunities for a parent-child transfer are maintained.
• May reduce tax in spousal arrangements — Because profits are being shared a spousal partnership may allow a larger split than if just wages were taken, particularly where both spouses are contributing capital. When the business is dispersed, both partners may be able to share in the assets appreciation, thus reducing tax.
• Allows siblings to share business — More than 1 child can farm together while testing the business relationship and sharing resources. If the siblings want to separate, a partnership it is easier to get out of, than a corporation.
• Allows for co-ownership arrangements — A partnership can be used in co-ownership arrangements to share high cost capital assets such as machinery, and increase the efficiency of the asset use.
• Lower costs — Partnerships are usually cheaper to establish and maintain than a corporation.
• Easier to dissolve — It is easier to dissolve a partnership than a corporation, allowing each partner to go his or her own way as a proprietor.
• No salary payments or deductions required — Because profits are shared salary payments and deductions are not required.
• Rollover provisions — Tax rules allow the transfer of assets from a proprietorship to a partnership without incurring any immediate tax provided the rules are followed and forms filed. Property can also be transferred from a partnership to a corporation on a tax-deferred basis.
• An interest in a farming partnership can be passed on to descendants either while alive or at death on a tax deferred basis.
• Capital gains — Any capital gains realized on the sale or transfer of a farm partnership interest may be eligible for the $500,000 capital gains exemption similar to shares of small business corporations.
• Deductibility of farm losses — Farm losses may be deductible from other sources of income. Sharing of the losses must be in a reasonable manner, not just one that offsets income for the partner employed elsewhere.

Disadvantages

• Legal liability for other partners — A partner in a partnership is not only liable for his/her own actions but is also jointly and severally liable for the actions of all partners. Unlike a corporation where liabilities are limited to an individual’s investment in the corporation and any guarantees provided, as a partner, all of the partner’s assets outside the partnership are exposed to creditors’ claims.
• No protection from individual tax rates — Compared to a corporation, a partnership does not provide any protection from the progressive rates of individual tax. Since the partners report income from a partnership personally, such income will be taxed at individual marginal tax rates.
• More complex than a sole proprietorship — Although partnerships are usually cheaper to establish and to maintain than a corporation, a partnership is a more complex arrangement than a sole proprietorship. Additional accounting information will have to be recorded each year so that the partners will be able to determine a tax value of their interest in the partnership as well as determine how profits are allocated.
• More complex record keeping — While poor records are a disadvantage in any business arrangement, if good records are not kept in a partnership it is difficult to know who has contributed or withdrawn funds and who owns what assets. It can be especially difficult to wind-up a partnership with incomplete records.

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 Statements

A 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 partner’s partnership interest is essential for an equitable dissolution of the partnership should that ever take place.

A Partnership Interest

The 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.

• Has the business relation ship between the partners been tested by farming together in a less formal business structure such as a revenue sharing arrangement?
• Do the advantages of a partnership outweigh a simple payment of wages to a spouse?
• Is the business is expected to carry on for more than 5 years to ensure cost of forming the partnership is recouped?
• Does a partnership complement future goals? For example is incorporating the business a future option that may be considered? Rolling a partnership interest into a corporation could allow some tax advantages to be utilised.

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 Partnership

A partnership structure may satisfy many of the criteria that the business has set, yet fail to match the family’s 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:

• keeping personal financial affairs separate from the partnership
• depending more on advisors for dealing with the tax and technical issues of the business
• sharing the management of the business with a partner
• communicating with the other partners on a regular basis

Section 2 — Forming The Partnership

Ownership Of Assets

A 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 Ownership

Assets owned by the partners

Pro’s

• partners can claim CCA
• simple to set up

Con’s

• Need to be clear on the partnerships usage of individuals assets

Assets owned by the partners and the partnership

Pro’s

• can bring children into business without transferring land

Con’s

• can be confusing

Assets owned by the partnership

Pro’s

• all assets in one place

Con’s

• more complex to set up

Assets Owned by Partners

In 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.

Assets Owned by Partners and Partnership

In 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.

Assets Owned by Partnership

In 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.

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.

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Steps In Forming A Partnership

There 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.

• Step 1 — (Optional) Transfer of some assets to a child (when this step is involved), with appropriate notes back.
• Step 2 — Transfer of assets from owners to partnership with appropriate assumption of debt, notes back and/or capital recognition.
• Step 3 — Establishment of a partnership agreement with appropriate operating rules, profit sharing formula, buy-sell clauses, clarification of ownership, dispute resolution, and dissolution.
• Step 4 — (Optional) Sale or gift of a partnership interest, documented by a transfer agreement and appropriate financing agreements.
• Step 5 — Appropriate clauses and agreement relating to the use or lease of assets retained outside of the partnership by individual partners.

Partnership Agreements

While 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:

• who owns the assets
• how profits and losses are to be divided amongst partners and the reasons for the allocation. This will reduce the chances of Canada Customs and Revenue Agency (CCRA) challenging the split
• how the partnership will decide what deductions will be claimed
• when partnership income is to be allocated to partners
• how income will be allocated if a partner decides to leave the partnership during the year
• the entitlement of income allowed to partners who leave the partnership during the year
• how disagreements will be solved, including the use of mediation
• the circumstances that allow the partnership to be dissolved
• the ability to buy-out other partners, how it should be done and at what value
• if property has been transferred into the partnership at cost, to whom any taxable income will be allocated when any accrued gain is realized
• which partner or partners have the authority to act for the partnership in making elections under the Income Tax Act.

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.

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Control of the partnership

In 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 Partnerships

Spousal 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-arm’s 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 partner’s 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.

• Did both spouses contribute original capital or make ongoing contributions of capital?
• Are both spouses registered on the ownership of assets?
• Can both spouses write cheques on the farm bank account?
• Do both spouses contribute labour and/or management to the farm business?

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 Trap

It 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.

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Tax Implications Of Forming A Partnership

The 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 Partnership

The 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 1

In 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

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Scenario 2

In 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. Table 11 in the appendix contains the tax details.

Table 5. Scenario 2 — Forming a Partnership

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Scenario 3

Here 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

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Section 3 — Operating The Partnership

Allocation Of Income To The Partners

The 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 Share

Net 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 Salaries

This 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 2^nd 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 C’s 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.