THE TAXATION OF PARTNERSHIPS
There are three types of persons and taxpayers for income tax purposes: an individual, a corporation, and a trust.
A partnership is not considered a person or a taxpayer. It is a relationship, generally defined as two or more persons carrying on business with a view to profit.
Therefore, a partnership does not file a tax return and does not pay taxes. (However, as noted below, a partnership may have to file an information form.) Instead, the partners report their shares of the partnership income or loss on their tax returns, along with their other income or losses. The partnership is essentially treated as a “flow-through” entity or relationship rather than a person.
Although a partnership does not pay tax, the Income Tax Act requires a notional calculation of the partnership’s income or loss as if the partnership were a person. The character of the income or loss (business income, property income, capital gains, etc.) is computed using the same rules that would apply to a taxpayer. In other words, most of the income inclusion and deduction rules (including items such as capital cost allowance) are notionally applied to the partnership.
The amount of the partnership income or loss is then divided among, or allocated to, each partner based on the partner’s share of the partnership. Each partner’s share is normally determined under the partnership agreement. The partner’s share of the income or loss is reported on the partner’s income tax return. This is done irrespective of whether the partnership has paid its income for the year out to the partners.
Adjustment to cost of partnership interest
The income allocated to a partner for a taxation year is added to the partner’s cost (adjusted cost base) of the partner’s interest in the partnership. Any loss so allocated is deducted in computing the partner’s cost of the interest.
Cash taken out of the partnership − the partner’s “draw” − is not taxed again (as noted above, the income to the partner is taxed when it is allocated to the partner). Instead, the cash draw reduces the partner’s cost of the interest.
The above rules ensure the appropriate amount of capital gain or loss if the partner sells the partnership interest.
You are a partner in a partnership. Last year, you were allocated $100,000 of the partnership's income and included that amount in your income. However, you did not take any of that cash out of the partnership. Your previous cost of the interest was $50,000.
Your "adjusted cost base" of the partnership interest will now be $150,000 − reflecting your previous cost plus the $100,000 allocated income. This ensures that, if you sell your interest now, you will not be taxed again on the $100,000 amount that was included in your income.
On the other hand, if you take out the $100,000 amount as a cash draw, your cost of the interest will be reduced back to $50,000. This result is appropriate, since your withdrawal of the $100,000 would normally reduce the value and potential sale price of your interest by the same amount.
Any tax credits are claimed by the partner rather than by the partnership.
Special rules may apply where the partnership pays an amount or otherwise undergoes a transaction that could trigger a tax credit.
For example, if the partnership makes a charitable donation, each partner will generally claim their pro-rata share of the charitable donation credit based on their share of the donation. Similarly, where the partnership makes a payment that qualifies for an investment tax credit, each partner will claim the credit based on the portion of the payment amount that can reasonably be considered to be the taxpayer’s share.
Although most of the above rules also apply to a limited partner of a partnership, one main difference applies when the partnership has losses. Typically, the limited partner may deduct its share of partnership losses only to the extent of the limited partner’s “at-risk amount” in respect of the interest.
In general terms, the at-risk amount is the partner’s cost of the interest, reduced by certain amounts such as the partner’s amount owing to the partnership, limited recourse debt used to acquire the interest, and any amounts or benefits to which the partner may be entitled that could serve to reduce the impact of any loss of the partnership allocated to the partner.
Partnership information return
Although a partnership does not file an income tax return, in some cases it must file an information return, Form T5013. The information return and its schedules require information such as the identity and addresses of the partners, the type of business, a summary of the partnership income, information about the partnership agreement, the partners’ shares of the partnership income, and various other items.
The information return is filed by Canadian partnerships and partnerships that carry on business in Canada. A Canadian partnership is one in which all the partners are resident in Canada.
However, the CRA provides that not all such partnerships are required to file the information return.
In particular, the CRA requires a partnership to file the return for a fiscal period only if:
- at the end of the fiscal period, the partnership has an absolute value of revenues plus an absolute value of expenses of more than $2 million, or has more than $5 million in assets; or
- at any time during the fiscal period:
- the partnership was part of a “tiered partnership” (it has another partnership as a partner or is itself a partner in another partnership);
- the partnership had a corporation or a trust as a partner;
- the partnership invested in flow-through shares that incurred Canadian resource expenses and renounced those expenses to the partnership; or
- the CRA requests that a return be filed.
The “absolute value” of a number is the value without regard to its positive or negative sign. Therefore, the $2 million revenue and expense threshold is determined by adding total worldwide expenses to total worldwide revenues.
If a partnership does not fall into one of the above categories, it is not required to file the return.
The CRA has also provided an administrative position that exempts farm partnerships from filing the return if they are made up of only individual partners. The exemption applied through the 2016 fiscal year. The CRA has not yet indicated whether the farm partnership exception will continue to apply for 2017, although we expect that it will.
If a partnership is required to file the T5013, each member is responsible for filing it. However, one member can file the return on behalf of all members; so only one return has to be filed for the partnership.