Introduction – Dissolution of a Partnership
Businesses can take many different forms under Canadian law. Sole proprietorships, corporations, partnerships, and trusts are among the most common types of legal forms for Canadian Businesses. Some businesses have a legal structure which is a combination of the above mentioned forms. The choice of legal form has significant tax and non-tax consequences for the business and its investors. In particular, the legal form chosen for a business will affect the tax consequences for investors when that business is shutdown. The focus of this article is on the tax consequences that arise when businesses structured as partnerships shut down.
A partnership is the relationship which subsists between persons carrying on a business in common with a view to profit. As such, a partnership is not treated by the law as a separate entity existing apart from its partners in the way that corporations are separate from their investors. While the partnership exists, its profits and losses are attributed to its partners for Canadian income tax purposes. The partnership itself does not pay Canadian income tax directly. When the partners cease to be carrying on a business in common with a view to profit, the partnership will have ceased to exist for most legal purposes. When the property of a dissolved partnership is distributed to the partners, it is treated as having been disposed of for fair market value at the time of the distribution, which can result in tax owing by the partners. If certain specific conditions are met, property can be distributed by a dissolved partnership on a tax deferred basis.
Dissolution of a Partnership – Deemed Existence of the Partnership
The law of partnerships falls under provincial jurisdiction, although the requirements to set up a partnership are similar in all of the common law provinces. When the factual conditions that give rise to a partnership, namely that persons are carrying on a business in common for a view to profit, cease to obtain, the partnership no longer exists for the purposes of provincial commercial law. These factual conditions can cease to exist before the partnership is fully wound up. For example, the business can stop operating before the remaining partnership property is distributed.
Subsection 98(1) of the Canadian Income Tax Act addresses this issue by deeming the partnership to continue to exist until all of the partnership's property has been distributed to those legally entitled to receive it. Similarly, the persons who were partners at the time the partnership ceased to exist are deemed to continue to be partners and to own an interest in the partnership. This means that partners continue to recognize their share of the partnership's income or loss for its fiscal period in the period after the partnership ceases to exist but before it is fully wound up. Additionally, the partnership is deemed to have a fiscal period which ends immediately before the partnership ceases to exist for the purposes of provincial law, though a partner who is an individual can elect under subsection 99(2) of the Canadian Income Tax Act to compute his or her income as if the partnership's fiscal period was unaffected by dissolution.
Dissolution of a Partnership – Tax Consequences of Distributing Partnership Property
When a partnership distributes partnership property to a person who was a partner immediately before the time of the distribution, the partnership is deemed to have disposed of the property at fair market value. The person receiving property from the partnership is deemed to have acquired the property at fair market value. This means that, subject to the special rules discussed below, the partnership will realize gains (or losses) on any property it distributes during the process of winding up. Since the partners at the time the partnership ceased to exist are deemed to remain partners until the process of winding up is complete, the income (or losses) associated with these distributions will be allocated to the partners and will be taxable in their hands.
Tax Deferred Distribution of Property on Dissolution – Conversion to Co-Ownership
In some situations it is possible for the property of a dissolved partnership to be distributed on a tax deferred basis. One such situation is where all the partners jointly elect to convert a Canadian partnership to co-ownership. A partnership is categorized as a Canadian partnership by the Canadian Income Tax Act at a particular time if at the particular time every member of the partnership is resident in Canada. If this is done, the partners must agree on a reasonable ownership percentage for each partner. Then all of the property is distributed to all the partners such that each partner is a co-owner of each property with a fractional interest in each property equal to their ownership percentage. The partnership is then deemed to have disposed of each property it held for proceeds of disposition equal to its cost amount, which means it will not realize any gains or losses to allocate to the partners. Each partner is deemed to have disposed of their interest in the partnership for proceeds of distribution equal to the greater of the two amounts:
- The partner's adjusted cost base of the partnership interest; and
- The partner's percentage share of the total combined cost amounts of all of the partnership's property.
This means that the partners cannot realize a loss on this disposition, and that they will realize a gain only if their percentage share of the partnership's combined cost amounts exceeds their adjusted cost base for their partnership interest. Even if a gain is realized, it is typically smaller than the gain that would realized if the partnership were treated as disposing of its property at fair market value. The partners are then deemed have cost amounts for each co-ownership interest equal to their ownership percentage multiplied by the partnership's cost amount for that property. If a partner realized a gain on the disposition of its interest in the partnership, then it may increase the cost amounts of any co-ownership interest in non-depreciable capital property it received to the extent of that gain as it designates, subject to the constraint that it cannot increase the cost amount of any particular co-ownership interest above that interest's fair market value.
Tax Deferred Distribution of Property on Dissolution – Conversion to Sole Proprietorship
When one, but not more than one, of the partners carries on the business of a Canadian partnership alone (referred to as the proprietor) within three months of the partnership ceasing to exist, then the distribution of the partnership's property to the proprietor is eligible for a tax deferred treatment similar to the one discussed above. Unlike when a partnership is converted into co-ownership, no election is required provided that the conditions described above are met.
The proprietor is deemed to have disposed of its interest in the partnership for proceeds of distribution equal to the greater of:
- The total combined adjusted cost base of each interest in the partnership held by the proprietor; and
- The total combined cost amounts to the partnership of all the property received by the proprietor plus any additional proceeds received by the proprietor on the cessation of the partnership.
The partnership is deemed to have disposed of each of its properties for proceeds of disposition equal to their respective cost amounts. This means that the partnership will not realize a gain and that the proprietor will not realize a gain so long as the second of the two amounts described above does not exceed the first of the two amounts described above. The proprietor inherits the partnership's cost amounts for all of the property it receives from the partnership. If the proprietor realized a gain on the disposition of its interest in the partnership, then it may increase the cost amounts of any non-depreciable capital property it received to the extent of that gain as it designates, subject to the constraint that it cannot increase the cost amount of any particular property above that property's fair market value.
Dissolution of a Partnership – Tax Deferred Distribution of Property on Dissolution – Incorporation of the Partnership
The legal form of a business can be changed from a partnership to Canadian corporation on a tax deferred basis. A corporation that is a tax resident of Canada and was incorporated in Canada is a Canadian corporation. Note that the partnership need not be a Canadian partnership for this treatment to be available and that requirements for a Canadian corporation are more flexible than those for a Canadian partnership. Subsection 85(2) of th e Canadian Income Tax Act allows for property to be transferred into a Canadian corporation in exchange for consideration that includes shares of that corporation on a tax deferred basis. If the partnership transfers its property to a Canadian corporation in exchange for consideration which includes shares of that corporation and winds up within sixty days of the transfer to the corporation, then it can distribute the consideration it received from the corporation to the partners on a tax deferred basis.
When the partnership distributes the property it received as consideration from the corporation to the partners, each partner's cost amount for any non-share consideration (typically cash or debt of the corporation) is equal to the fair market value of that property. The aggregate cost amount for the share consideration received by each partner is equal to the cost amount of that partner's partnership interest minus the fair market value of the non-share consideration they received (though no less than zero). Each partner is then deemed to have disposed of their interest in the partnership for an amount equal to the combined cost amount of the property they received from the partnership. This means that unless the partner received non-share property with a fair market value greater than the cost amount of their partnership interest, they will not realize a gain. The partnership is deemed to have disposed of the consideration which it received from the corporation for proceeds of disposition equal to its cost amount for the consideration, so it does not realize a gain or loss.
Tax Deferred Distribution of Property on Dissolution – Continuation of the Partnership
In most provinces, in the absence of a partnership agreement with a provision that explicitly provides otherwise, the death or insolvency of any partner causes the partnership to cease to exist. This could result in a constructive distribution of partnership assets to the partners with attendant tax consequences, even if the remaining partners continue the business of the partnership. The Canadian Income Tax Act has partially addressed these issues by allowing automatic tax deferred transfers of partnership property from a predecessor partnership to a successor partnership in certain circumstances.
For tax deferred treatment to apply, both the predecessor partnership and the successor partnership must be Canadian partnerships. The predecessor partnership must also transfer all of its property to the successor partnership before or at the time the predecessor partnership ceases to exist. The successor partnership cannot have any members who were not members of the predecessor partnership. If all of these conditions are met, the successor partnership is deemed to be a continuation of the predecessor partnership, and the partnership interests of members of the successor partnership are deemed to be continuations of their partnership interests in the predecessor partnership.
Dissolution of a Partnership - Tax Tips
The rules governing the tax consequences of the dissolution of partnerships are complex. The account given above is a simplified summary and does not cover all the details that need to be considered when a partnership is dissolved. If you had an interest in a partnership that has dissolved or if you are contemplating a reorganization which could involve the dissolution of a partnership, it is essential to consult an experienced Toronto tax lawyer.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.