Chapter Objectives Be able to: Identify when a partnership exists. Explain what is included in a standard partnership agreement. Explain partner liability. Explain how partnership income is taxed. Explain how the disposition of partnership interests are taxed. Explain how transactions between the partnership and its partners are taxed. Explain how partnerships can take advantage of the small business deduction.

Partnerships A partnership is the relationship that exists between entities carrying on a business in common with a view to a profit. A joint venture is different since it is usually formed for a single purpose or a single transaction. A partnership is created by the execution of a partnership agreement which sets out the working framework of the entity, particularly in the fundamental areas of required partner contributions, management of the business, and the allocation of profits and losses. Partner contributions can be in the form of cash or specific assets. The format of management decision making and the allocation of profits and losses is flexible and there need not be any relationship to a partner’s ownership interest. Another key feature is that a partner is fully liable for all obligations and debts of the partnership regardless of ownership interest.

Taxation of Partnership Income and Interests A Partnership is not a taxable entity. Instead income earned or losses incurred are allocated to partners, in the agreed upon ratio, for inclusion in the partner’s net income for tax purposes. Income is allocated to partners regardless of actual payment. However, when retained profits are paid to the partners, it is a return of capital and is not included in income of the partner. Income allocated to partners retains its source and characteristics when included in a partner’s income. That is, dividend and capital gain income of the partnership become dividend and capital gain income of a partner. A partnership interest is capital property and, thus, its disposition will result in a capital gain or loss. Since retained profits are added to a partnership interest’s cost base, capital gains will be reduced accordingly.

Taxation of Partnerships - Other Although partnerships are a non-taxable entity, assets sold to a partnership are deemed to be at fair market value unless an election is made to use an elected amount, such as tax cost. As a result, business income and/or capital gains could result for the partner. There is a similar treatment for assets sold by a partnership. However, the resulting business income and/or capital gains would be partnership income and allocated as is to the partners. A partnership is eligible for the small business deduction but it is allocated to the partners in the same ratio as profits. Furthermore, the portion allocated to a partner becomes part of that partner’s small business deduction, as opposed to an addition to it. In effect, the allocation of partnership income to a partner in excess of the allocated small business deduction to that partner is not eligible for the small business deduction.