Navigating Partnership Interests and Tax Consequences

Introduction

Partnerships are a common business structure, and understanding the taxation of partnership interests is essential for partners and investors. A partnership interest is a complex property for income tax purposes, similar to owning shares in a corporation. In this guide, we will explore the concept of partnership interests and delve into their taxation through practical examples.

The Concept of Partnership Interest

What is a Partnership Interest?

A partnership interest comprises the rights of a partner in a partnership. These rights include participation in profits and losses of the partnership and an ownership stake in partnership assets, especially during dissolution. Similar to owning stock in a corporation, a partnership interest is considered a property for income tax purposes.

Taxation of Partnership Interests

Typically, a partnership interest is regarded as non-depreciable capital property held to earn business or property income. Consequently, disposing of a partnership interest usually results in a capital gain or loss.

Acquiring a Partnership Interest

New Partnership

When forming a new partnership, determining the adjusted cost base (ACB) of the partnership interest is straightforward. The ACB equals the fair value of assets contributed to the partnership. If non-monetary assets are involved, appraisals may be necessary, but this doesn't alter the basic concept.

Admission to an Existing Partnership

Admission to an existing partnership can occur through two methods: buying an interest directly from a partner or acquiring an interest from the partnership by transferring assets.

Purchasing an Interest from a Partner

When purchasing an interest directly from an existing partner, the cost equals the purchase price. For instance, if Mr. Kim acquires Mr. Boland's one-third interest for $90,000, both Mr. Kim's cost and Mr. Boland's proceeds of disposition would be $90,000.

Purchasing an Interest from the Partnership using Assets

In cases where the partnership interest is acquired by transferring assets directly to the partnership, no tax consequences occur for existing partners. No disposition of their interest occurs, and therefore, no capital gain is recorded. The new partner's interest is recorded at the cost of the assets transferred, e.g., $90,000.

Let's understand admission of a new partner with an example below.

Real World Example

Consider an existing partnership named ABC Enterprises that has three equal partners: Sarah, Mike, and Emily. Each of them has made a capital contribution of $20,000. They would like to bring in a new equal partner, Mr. Johnson, with the goal of ensuring that each partner retains a 25 percent interest in the organization. Mr. Johnson agrees to pay $40,000 to each of the existing partners for one-quarter of their one-third interest. This arrangement ensures that each partner maintains a 25 percent interest [(75%)(1/3) = 25%].

ANALYSIS:

‍Mr. Johnson would have an Adjusted Cost Base (ACB) of $120,000, which represents the consideration given up for the 25 percent interest.

Each of the original partners (Sarah, Mike, and Emily) would have a capital gain calculated as follows:

Proceeds Of Disposition To Each Partner: $40,000

ACB of Part Interest [(25%)($20,000)]: ($5,000)

Capital Gain For Each Partner: $35,000

The capital accounts in the accounting records of the partnership and the partners' ACB will be as follows:

• Sarah's Capital Before Admitting Mr. Johnson: $20,000
• Mike's Capital Before Admitting Mr. Johnson: $20,000
• Emily's Capital Before Admitting Mr. Johnson: $20,000
• Mr. Johnson's Contribution: $120,000

Adjustment For Admission Of Mr. Johnson:

• Sarah: ($5,000)
• Mike: ($5,000)
• Emily: ($5,000)
• Mr. Johnson: $15,000

Ending Capital Accounts:

• Sarah: $15,000
• Mike: $15,000
• Emily: $15,000
• Mr. Johnson: $15,000

ACB Of Partnership Interest:

• Sarah: $15,000
• Mike: $15,000
• Emily: $15,000
• Mr. Johnson: $120,000

Note that while the accounting values for the interests of the original three partners are equal to their ACBs, this is not the case for Mr. Johnson. In contrast to his accounting value of $15,000, his ACB would be his cost of $120,000 [(3)($40,000)].

In this example, we have only considered situations where assets were given to specific partners in return for the new partner’s acquired interest. There are also situations in which the new partner makes a payment directly to the partnership in return for his or her interest.

If Mr. Johnson had paid the $120,000 directly to the partnership, there would be no tax consequences for the existing partners (Sarah, Mike, and Emily). No disposition of any part of their interest would have occurred, and as a consequence, no capital gain would be recorded, and the ACBs of their interests would remain at $20,000. Mr. Johnson's interest would be recorded at $120,000 for both tax and accounting purposes.

Adjusted Cost Base (ACB)

The adjusted cost base (ACB) of a partnership interest is crucial for tax purposes. ACB is determined by starting with the ACB of the preceding year and adjusting it for various items, including income allocations, drawings, capital contributions, dividends, and more.

Timing of Adjustments

Adjustments for income allocations, drawings, and dividends are made on the first day of the following fiscal period. Let's explore these adjustments.

Adjustments for Income Allocations

Partnership income is allocated based on the partnership agreement. The allocated income, whether business income or capital gains/losses, is added to or subtracted from the partner's ACB on the first day of the following fiscal period.

Example: In a partnership with four equal partners and a December 31, 2019 year end, each partner initially contributed $2,000. In 2020, they earned $20,000 in gross service revenue. Each partner's share of business income ($5,000 each) would be added to their ACB on January 1, 2021.

Adjustments for Capital Contributions and Drawings

Net capital contributions increase the ACB, while drawings decrease it. These adjustments occur when the contributions or drawings take place.

Example: If Mr. A's partnership interest has an ACB of $20,450 at January 1, 2020, and he contributes $8,200 in March 2020 while making withdrawals of $2,000 in May, August, and November 2020, his ACB would be calculated as $22,650.

Adjustments for Dividends

Dividends, whether eligible, non-eligible, or capital, are allocated based on the partnership agreement. The full amount of dividends is added to the ACB on the first day of the following fiscal period.

Negative ACB

A negative adjusted cost base (ACB) can occur when withdrawals exceed the initial ACB and positive adjustments. Special provisions allow general partners to carry forward a negative ACB until they dispose of their interest. This deferral is beneficial for tax purposes and is also applicable in cases of deemed disposition at death.

Limited Partnerships and Limited Partners

In a limited partnership, there are limited partners who have limited liability and active general partners who manage the business. Taxation rules for limited partners differ from those for general partners.

Disposition of a Partnership Interest

When a partner disposes off their interest in a partnership, it can have significant tax implications. Disposition typically occurs through two main scenarios: selling the interest to an arm's length party or withdrawing from the partnership.

Sale to an Arm's Length Party

If a partnership interest is sold to a party that is not related to the seller (an arm's length party), the tax consequences are relatively straightforward. The calculation involves subtracting the adjusted cost base (ACB) of the partnership interest from the proceeds resulting from the sale.

• If the result is positive, it represents a capital gain. One-half of this gain will be taxed in the hands of the partner.
• If the result is negative, one-half of the amount becomes an allowable capital loss, which can be deducted by the partner to offset any current year taxable capital gains. Any unused capital loss can be carried over to previous and subsequent years for deduction.

Example: Suppose Partner A sells their partnership interest to an unrelated third party for $120,000, and the ACB of their interest is $90,000. In this case, Partner A would realize a capital gain of $30,000 ($120,000 - $90,000). They would include $15,000 (one-half of the gain) in their taxable income.

Withdrawal from the Partnership

When a partner withdraws from a partnership, it's essentially a disposition of their interest. The most common scenario involves the remaining partner(s) buying out the withdrawing partner's interest. Here's how it works:

Example: Consider the ABC Partnership with three partners: A, B, and C. C decides to retire and withdraws from the partnership. In return, A and B each pay C $175,000 for C's interest.

• Partner C would incur a taxable capital gain, which is calculated by comparing the proceeds received from A and B to the ACB of C's partnership interest.
• For A and B, there are no immediate tax consequences. However, their ACB for their remaining interests would increase by the amount paid to C.

This process ensures that the tax implications are fair for both the withdrawing partner and the remaining partners.

Conclusion

Understanding partnership interests and their adjusted cost base is essential for tax planning in partnerships. These concepts play a vital role in determining capital gains or losses when disposing of partnership interests and can significantly impact a partner's tax liability. Proper tracking and accounting are crucial to ensure compliance with tax regulations and optimize tax outcomes in partnership arrangements.

If you’d like to learn more or would need help with a similar tax issue, please reach out to us at help@futurecpa.ca.