What is a partnership?
It has been established that for a partnership to exist, there must be a business carried on by two or more people with the intention to generate a profit.

With this in mind, a partnership can be made up of related or unrelated people. While corporations can also be partners, this article will focus on partnerships between individuals.

Setting up a partnership
Once it has been determined that a partnership will be used, the first step is to have a partnership agreement prepared.

The partnership agreement identifies the partners, discusses how profits are to be allocated, governance and operations, what happens if a partner dies or leaves as well as a number of other issues.

While it is common that taxpayers, particularly spouses, file income tax returns as a partnership without having a partnership agreement in place, the agreement helps deal with issues that may occur throughout the life of the partnership as well as help validate the partnership if questioned by Canada Revenue Agency (CRA).

If an individual has been farming for years as a sole proprietor and then decides to form a partnership, it is not as simple as just adding a new partner.

An income tax election under section 97(2) of the Income Tax Act should be used in this case to transfer the farming assets of the individual into the partnership on a tax-deferred basis.

If this step is not done, the individual with the farming assets could be viewed by CRA to have sold all their assets to the partnership at fair market value, a result which may not be a favorable one. Prior to commencing operations and having assets transferred to it, the partnership should be registered for GST/HST.

Taxation of partnerships
A partnership with at least one individual as a partner must have a December 31 year-end for income tax purposes.

Net income is calculated at the partnership level and then split between the partners based on a predetermined method of allocation.

Various items such as capital cost allowance, allowance on eligible capital property and optional and mandatory inventory adjustments are claimed at the partnership level before the income is split.

For example, Mr. and Mrs. Jones have a farm partnership in which they split the income 60-40. Their revenue and expenses are as follows:

Income                                          $100,000
Expenses                                      ($70,000)
Capital cost allowance                  ($15,000)
Net income                                    $15,000
Mr. Jones’ share                              $9,000
Mrs. Jones’ share                            $6,000
Total                                               $15,000

There are certain expenses which should be considered when calculating your partnership income.

Salaries paid to the partners are not deductible as expenses in the partnership but rather would be considered distribution of the equity of the partnership.

Property taxes and mortgage interest on land held by one or more of the partners should not be expensed if the intention is to leave the land out of the partnership.

A more effective approach would be for the partnership to rent the land from the individual partners.

Care should be taken to record this rental income on a rental schedule on the partner’s personal income tax return and deduct the property taxes and interest against that rental income. GST/HST would be required on this transaction if the individuals were registered.

It is possible for a partner to claim expenses against their partnership income after it has been allocated.

These may be expenses the individual partner paid for rather than being paid by the partnership.

CRA may challenge the allocation used, so care should be taken to ensure that it is reasonable taking into account capital invested and work performed.

Treatment of a partnership interest
A partner is considered to own an interest in the partnership. This interest is considered to be a capital property for income tax purposes.

When the partnership is a family farm partnership, the Income Tax Act allows some favorable treatments of the partnership interest.

These include the ability to sell the partnership interest, sheltering the gain with the capital gains deduction or to use the farm rollover rules to transfer the partnership interest to a child or grandchild on a tax-deferred basis.

For example, Mr. Smith and his son, Ryan, have a farm partnership. Mr. Smith has decided that he no longer wishes to farm, while his son wishes to continue farming. Ryan’s wife, Jill, is very involved in the farming operation.

Because a daughter-in-law is considered to be a child for purposes of this section of the Income Tax Act, Mr. Smith can transfer his partnership interest to Jill on a tax-deferred basis, and the farm partnership will continue on with Ryan and Jill as the partners.

Incorporation of a farm partnership
An effective tax planning opportunity is available which enables partners in a farm partnership to sell their partnership interest to a corporation and use their capital gains deduction provided the partnership interest qualifies for the deduction.

Normally, when we think of the capital gains deduction, we think of its availability in the sale of farm land, farm quotas, and to a lesser extent, on the sale of shares in a farm corporation.

Using the capital gains deduction to sell a partnership interest into a corporation can be an effective way to ultimately transfer farm assets such as inventory or equipment at their fair market value while taking back a tax-free promissory note from the corporation.

Take, for example, the situation where Mr. and Mrs. Jones have a farm partnership with the following assets and liabilities at their fair market value:

Cattle                                                        $800,000
Grain                                                         $300,000
Equipment                                                $500,000
Total assets                                           $1,600,000

Less debt on equipment                          $100,000
Value of partnership                             $1,500,000

Mr. and Mrs. Jones each have a partnership interest worth $750,000. They also have all of their capital gains deduction, which is also $750,000.

Mr. and Mrs. Jones can sell their partnership interests to a corporation to offset the capital gain resulting from the sale with the capital gains deduction and take back promissory notes from the corporation of $750,000 each.

As there is now only one partner (i.e., the corporation), the partnership ceases, and as long as the corporation continues to carry on the farming business, the assets and liability then roll out into the corporation on a tax-free basis, leaving them the ability to sell the cattle and grain at a low corporate tax rate and take out the after-tax dollars without tax.

Use of a farm partnership to qualify land for the capital gains deduction
Sometimes situations occur where farm land may not qualify for the capital gains deduction because the owner of the land has gross income from another source which exceeds his farming income.

One way to make this land qualify is to set up a family farm partnership. The partnership, whose only source of income is farming income, can then farm the land for two years, enabling the land to qualify for the deduction provided all other rules are met.

Conclusion
The above article discusses farm partnerships in general as well as a few tax planning opportunities available.

The concepts have been explained in general terms, so consider contacting a tax adviser to assess your particular situation and determine how a farm partnership may help you.  PD

—Excerpts from Collins Barrow Farm Alert newsletter, January 2013

Robert Fischer
Partner
Collins Barrow Red Deer LLP