Although the majority of farms in Canada are operated as proprietorships (which I discussed in my December article), there are many farm businesses that would be better structured as a general partnership. In the business of farming, family partnerships — for example, parent/child or spousal/common-law partner arrangements — are popular choices.
What defines a partnership?
Next to proprietorships, partnerships are the oldest form of business organization recognized in the English law. While there is no definition of partnership in the Income Tax Act, each province has a statute that deals with the legal issues of partnerships, usually called The Partnerships Act.
A partnership involves two or more persons who carry on a business in common, with the intent of making a profit, that is not organized as a corporation. The relationship may be either informal or documented via a formal partnership agreement that sets out the rights and obligations of the partners.
While there are both general and limited partnerships, only general partnerships are common in farming. In this type of arrangement, each partner shares in the ownership, management and liability of the farm business.
Each partner is equally liable for any and all payments or actions of the business whether incurred personally or by a partner. Each partner is allocated a portion of the profit or loss incurred by the partnership and is responsible to pay taxes on such income. Each partner can bind the partnership and, as a consequence, all other partners in matters relating to the business.
The partnership is not a separate legal entity from its owners in the way a corporation is a separate legal entity from its shareholders.
What are the advantages of a partnership?
1. Ability to share the high cost of capital.
One of the main advantages over a proprietorship is that multiple partners usually bring more financial and other resources to a partnership. It can be a big plus to be able to share the cost, as well as the risk, of owning expensive farm machinery such as combines.
2. Ease of formation, structure, and liquidation.
Most partnerships are set up on a very informal basis and can easily be structured to compensate partners for their respective contributions, such as capital, time and management. Under relevant provincial law, a partnership automatically terminates if one partner leaves or dies, unless there is a partnership agreement with a continuation clause.
3. Flow through of losses in formative years.
If a partnership can fulfill the “reasonable expec-
tation of profit” criteria, partners can use potential losses during start-up against other sources of personal income whether or not they have withdrawn funds from the partnership during the year.
4. Wages for family members who provide services.
While a partner’s drawings are not deemed to be an expense to the partnership, reasonable wages can be paid to non-partner family members for services rendered and deducted by the partnership. Often in family farm partnerships children are paid a wage, usually with a profit-sharing component to the compensation, until they are ready to join the partnership.
What are the disadvantages of a partnership?
1. Frequent lack of formal written agreements.
While partnerships are simple to set up because there is no need for written agreements, if you do not formalize the arrangements in writing, problems can arise down the road, particularly when it comes to income allocation or exit mechanisms. A partnership agreement can, for example, be written to allow for net profit allocations that vary on an annual basis.
2. Unlimited liability.
The irresponsible actions of one partner acting on behalf of the partnership could affect the liability of all partners.
3. High income taxes and potential tax complications.
Non-corporate partners are taxed at their personal, often high, marginal tax rates. In addition, the tax rules are far more complex for partnerships than for proprietorships, and compliance can be complicated. Partnerships with more than five partners are required to file an annual Partnership Information Return (T5013).
4. Maintaining adjusted cost base (ACB) of partnership interests.
Maintaining the ACB of partnership interests can be an onerous task, but it must be done to facilitate either the potential sale of an interest or a transfer to the next generation at some point in the future.
5. No subdivision of partnership interest in transfer to spouse upon death.
When a partner in a farm partnership dies and transfers his or her interest in the partnership to his or her spouse, it will generally roll over to the spouse at cost. In some cases, the transfer can be done at fair market value, using some of the deceased’s available lifetime capital gains exemption, but the total partnership interest must be included if using this option.
Farm spousal partnerships can use income splitting
Although partnerships can experience high income taxes, it must be noted that many farm couples operate their farm businesses as partnerships so they can use income-splitting opportunities to achieve overall family tax savings.
With the progressive tax systems of the federal and most provincial governments, income splitting can give the spouses access to lower marginal tax rates for their personal tax returns and also generate tax savings through other deductions and credits available to family members. These include various non-refundable tax credits, including those for charitable and political contributions, tuition and education amounts, and medical expenses; loss carry-forwards that would otherwise expire or be used to shelter income in a low tax bracket; capital gains deductions and exemptions from provincial income-based premiums or taxes such as the Ontario Health Premium.
Partnerships are often established as a first step in preparation for the eventual incorporation of a farm business. Before setting up a farm partnership, however, the prudent approach is to seek input and guidance from your tax and legal advisors. CG
This article was prepared by FBC tax analyst Larry Roche. FBC has specialized in farm tax matters for 55 years, and now serves 50,000 members from branches in British Columbia, Alberta, Saskatchewan, Manitoba and Ontario. You can visit the FBC website atwww.fbc.ca. If you have any questions about this article, please send an email message to[email protected] or call 1-800-860-7011 toll-free.