On August 1, 2007, new amendments to section 10 of the Ontario Partnerships Act1 will come into force that create full shield limited liability protection. Because of these amendments, negative tax implications may occur for partners in a limited liability partnership ("LLP").
The new amendments stipulate that a partner in a LLP is not liable, by means of indemnification, contribution or otherwise, for
the debts, liabilities or obligations of the partnership or any partner arising from the negligent or wrongful acts or omissions that another partner or an employee, agent or representative of the partnership commits in the course of the partnership business; or
any other debts or obligations of the partnership that are incurred.
However, this does not relieve a partner in a LLP from liability for
the partner's own negligent or wrongful act or omission;
the negligent or wrongful act or omission of a person under the partner's direct supervision; or
the negligent or wrongful act or omission of another partner or an employee of the partnership not under the partner's direct supervision if
i. the act or omission was criminal or constituted fraud, even if there was no criminal act or omission, or
ii. the partner knew or ought to have known of the act or omission and did not take the actions that a reasonable person would have taken to prevent it.
Furthermore, full shield limited liability protection will not protect a partner's interest in the partnership property from claims against the partnership respecting a partnership obligation.
Until the new amendments come into force in August, the Ontario Partnerships Act provides only partial shield limited liability protection to a partner in a LLP for debts, obligations and liabilities of the partnership or any partner arising from negligent acts or omissions that another partner or an employee, agent or representative of the partnership commits in the course of the partnership business.
Because partial shield limited liability protection does not protect against the liabilities for the general debts of the partnership, partners in a partial shield LLP are treated as a general partner for income tax purposes. A partner in a full shield LLP is treated as a limited partner for income tax purposes because (1) their personal liability, including liability for the general debts of the partnership, is limited, and (2) they can withdraw capital or be allocated losses so that their interest in the LLP becomes negative.
This means that a partner in a LLP must calculate their Adjusted Cost Base ("ACB"), and if their partnership interest is negative at fiscal year end, they will have a deemed capital gain equal to the amount by which the ACB is negative.
ACB is calculated by:
A partner's capital invested in the partnership; and
All taxable income earned from the partnership while a partner; and
Any increases in ACB resulting from certain capital gains elections,
And then subtracting:
Allocations of partnership losses to the partner from previous fiscal periods; and
All draws or distributions of partnership profit or capital.
In making this calculation, the Canadian Income Tax Act2 provides that income from the partnership for each year is not added to a partner's ACB until immediately after the partnership's fiscal year-end. This creates a significant timing issue which frequently results in a negative ACB. The federal government has agreed to change the timing of the addition of taxable income from a LLP to the partner's ACB in their partnership interest to coincide with the partnership's fiscal year end, which should resolve the negative ACB issue for many partners in a full shield LLP, but not all.
ACB in a partnership interest may be negative in many other situations, such as where:
Partners have invested very little capital in the partnership, or where a partner has withdrawn capital from a partnership;
A partner's income has been reduced, but his or her draws have not been adjusted during the year, and exceed taxable income;
Partners draw on accounting income and work in progress in excess of their taxable income;
A partnership borrows to finance substantially all operations, including work in progress and disbursements; and
New partners receive draws in excess of the income allocated to them in accordance with the terms of their partnership admission.
The bottom line is that partners will have to monitor their ACBs annually to ensure that they are not negative at any fiscal year-end to avoid this unintended tax consequence.
1. R.S.O. 1990, c. P.5.
2. R.S.C. 1985, c. 1 (5th Supp.).
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