lifecycle of a partnership freeze - tax...

t February-8-12 1

Lifecycle of a Partnership Freeze

Presented by Penny Leckie, CA, CMA, TEP

March 16, 2004

Calgary, Alberta

t February-8-12 2

Objectives

• Outline lifecycle of a partnership freeze

• Planning and implementation

• Operation and effective use

• Death of the “freezor”

• Winding up

• Planning opportunities

t February-8-12 3

Planning Opportunities

• Real property inventory

• Transfers under 97(1) crystallize losses forward

• Mitigate exposure to kiddie-tax provisions

• Transfer QSBC shares, increase acb, multiply access

• No double taxation on death

• Multiple partnerships

• “Bump” basis on windup

t February-8-12 4

Planning and Implementation

• Define Objectives of the Freezor

• Similar to any estate freeze

• Partnership freeze can achieve majority of objectives

• Additional planning opportunities

• Flexibility

t February-8-12 5


• Identify potential partners

• Individual, corporation, family members, trust

• “Alter” identity of partner, if necessary

• Non-residents

• Minor children

t February-8-12 6

Basic Partnership Freeze

Freezor Family

Trust

Partnership

Parties intended to participate in future

growth subscribe for “common” units at

nominal amount

Assets transferred to

partnership in exchange for

“preferred” partnership units

Business Assets

t February-8-12 7

Subsection 97(2)

• Tax deferred rollover to partnership

• Criteria

• Joint election

• One partner typically acts on behalf of all partners to simplify administration

t February-8-12 8

Canadian Partnership

• Immediately after transfer

• Defined in subsection 102(1)

• All the members must be resident in Canada

• Example – non resident child

• Solution – acquire interest after rollover

t February-8-12 9

Canadian Partnership

• Withholding tax issues

• Solution – resident in Canada, ie corporation or trust, hold partnership interest

• Ceasing residency, transfer partnership interest to Canadian entity

t February-8-12 10

Eligible Property

• Similar to 85(1)

• Capital property, Canadian resource property, foreign resource property, eligible capital property

• Inventory, including real property

t February-8-12 11

Real Property Inventory

• Transfer property to partnership 97(2)

• Transfer partnership interest to corporation 85(1)

• GAAR, IC 88-2, paragraph 22

• Loyens case

t February-8-12 12

Proceeds of Disposition

• Amounts may elect are similar to 85(1)

• Consider cost of asset transferred, fair market value, and consideration received in exchange

• Careful if debt involved

• Amount elected becomes proceeds of disposition on assets transferred

• Amount elected becomes cost base of assets received

t February-8-12 13

ACB of Partnership Unit

• Initial cost base is cost, or elected amount

• Cumulative calculation

• Adjustments in 53(1)(e) and 53(2)(c )

• Income and loss of partnership

• Contributions and withdrawals

• Timing may be critical

t February-8-12 14

Deemed Proceeds of Disposition

• 40(3.1) deemed disposition if negative acb

• No deemed disposition to general partner

• Cases re thinly disguised sale of assets

• Stursberg case

• Withdrawals deemed to be proceeds of disposition, unintended results

t February-8-12 15

Subsection 97(1)

• If 97(2) criteria not met, 97(1) applies

• Property deemed to be acquired from partners at fair market value

• Potential for onerous tax results

• Potential planning opportunities

t February-8-12 16

Stop-loss Provisions

• Subsection 40(3.3) and 13(21.2)

• Prevent realization of losses to affiliated person

• Subsection 251.1(1) provides partnership affiliations

• Majority interest partner

• Transfers from individuals not subject to “stop-loss”

• Superficial loss provisions in Section 54 apply

t February-8-12 17

Preferred Unit Attributes

• Consider guidelines for preferred shares

• Preference to other classes of units

• Price adjustment clause

• Consider return of capital

t February-8-12 18

Preferred Unit Attributes

• Limitation on draws by growth unitholders

• Entitled to realized gain on assets transferred

• Future capital growth allocated to growth units

• Income on reinvested funds shared pro-rata

t February-8-12 19

Partnership Unit Attributes

• Each situation unique

• Driven by personal and business issues

• Important to ensure that sufficient value is received by freezor

t February-8-12 20

Liability

• Need to understand potential exposure

• Limited or unlimited liability – will depend on situation

• Solution – structure as limited partnership with general partner

• Solution – hold partnership interests through corporations

t February-8-12 21

Control

• Give up growth, but not control

• Corporation act as general partner, with authority to act

• Freezor controls corporation that is general partner

• Outline management in partnership agreement

• Terms of preferred partnership units

t February-8-12 22


• General estate freeze concerns

• May not be able to resolve all in partnership structure

• Resolve in overall design of estate

t February-8-12 23

Existence of a Partnership

• Concern

• Does a partnership actually exist

• Rollover under 97(2) requires transfer to a partnership

• If no partnership, transfer fully taxable

• Issue is usually manageable

t February-8-12 24

Description of a Partnership

• No definition in ITA

• Comments in IT-90

• Relationship between persons carrying on a business in common with a view to profit

• Written agreement not required

• If no business in common, or no view to profit, partnership may not exist

t February-8-12 25

Definition of Business

• Broad definition

• Subsection 248(1)

• Profession, calling, trade, manufacture, or undertaking of any kind, whatever, an adventure or concern in the nature of trade

• If not self-evident, care necessary in structuring and documentation

• Continental Bank Leasing case

t February-8-12 26

CRA Position

• Concern, recognition by CRA

• No indication that CRA will accept structure

• No indication that they will not accept structure

• In comments, rely on provisions 103(1) and 103(1.1)

• Uncertainty is major roadblock

t February-8-12 27

Subsection 103(1)

• Where members have agreed to share income or loss

• Principal reason for agreement

• Reduction or postponement of tax

• CRA may reallocate to amount that is reasonable in circumstances

t February-8-12 28

Subsection 103(1.1)

• Members of a partnership are not dealing at arm’s length

• Agree to share income or loss

• Amount not reasonable in circumstances

• Regard to capital invested and work performed

• CRA may reallocate to amount that is reasonable in circumstances

t February-8-12 29

Subsections 103(1) & 103(1.1)

• Discretion to challenge unreasonable allocations

• Different discretion in each provision

• 103(1) requires principal reason to be reduction or postponement of tax

• 103(1.1) when related parties involved, income may be reallocated in any circumstances that allocation is not considered reasonable

t February-8-12 30

CRA’s Position

• Consistent

• Contingent upon facts applicable in each unique set of circumstances

• Consider examples

t February-8-12 31

Example – Does 103(1.1) apply?

Father Inactive Active

Partnership

Preferred partnership

Units valued at $1M,

5% return on capital,

annually

50% of common interests,

Equal share of annual profits

Business with fmv of $1M,

Annual income of $250,000

t February-8-12 32

Does 103(1.1) apply?

• Likely

• Partners do not deal at arm’s length

• Income allocations not reasonable given relative contributions of capital and involvement in business

t February-8-12 33


Father

Inactive

Active

Partnership




annually

Common interests,

Annual profits

Business with fmv of $1M,


Provided for with

other assets

t February-8-12 34


• Depends

• Guidance in IT-231R2

• Level of involvement

• Value placed on involvement

• Value placed on talents and skills

t February-8-12 35

Income allocations

• Jurisprudence is limited

• Majority of cases re spouses, time spent and level of expertise

• Compared to arm’s length situations

• Fraser case

t February-8-12 36

Members of a Partnership

• Wording in 103(1) & 103(1.1) refers only to members

• No ability to reallocate to related parties that are not members

• Consider a related corporation that is not a member

t February-8-12 37


Father Active

Partnership




annually

Common interests,

Annual profits

Rental properties with fmv of $1M,


Management

company

Inactive

Management contract

$200,000 per year

t February-8-12 38

Management Corporation

• Assume active business income

• Assume not personal services business

• $200,000 management services contract is eligible for small business deduction

• Income effectively taxed at lower rate than if allocated directly to daughter that is a partner

t February-8-12 39


• Corporation is not a member of partnership

• Difficult to apply

• Consider definition of partnership

• Written agreement not required, based on relationship

• Could corporation be considered a partner?

t February-8-12 40


• Presume that corporation not a member of the partnership

• Members of the partnership agreed to enter into the contract

• Members of the partnership agreed to income allocation

• Could CRA be successful?

• No jurisprudence where income distributed to related, non-members

t February-8-12 41

CRA approach

• More likely to rely on Section 67

• Limits deductibility unless reasonable

• Easier argument to make

• However, argument still based on facts and circumstances

• Difficult to prove if daughter working long hours and charging fees through corporation

t February-8-12 42

Capital Contributions

• IT-231R2 – Partners Not Dealing at Arm’s Length

• If funded by gift or loan from another partner that is non-arm’s length, considered to be contribution by original party

• Beyond scope of 103(1.1)

• Source of capital is not relevant

t February-8-12 43

Subsections 103(1) and 103(1.1)

• Powerful tool to challenge income allocations

• Lack of jurisprudence and administrative positions with actual scenarios

• Use caution when drafting documents for partnership freeze

• Arm’s length approach

• Support with rationale

t February-8-12 44

Attribution

• Source of capital should not be basis under 103(1.1)

• However, if gift is made to certain related parties and a partnership interest acquired, regular attribution provisions may apply

• 74.1(1), 74.1(2) and 74.3(1) will apply to attribute income to individual that made gift

• Subsection 74.2(1) will attribute capital gains from spouse

• If transfer for fair market value, 74.5(1) prevents attribution

t February-8-12 45

Attribution

• Subsection 56(4.1) attributes income if loan made to related party to reduce or avoid tax

• Exception under 56(4.2) for loans with prescribed rates of interest

t February-8-12 46

Attribution

• Applies to income from property

• Subsection 96(1.8) deems income received from partnership to be income from property for purposes of attribution provisions

• Planning should provide for fair market consideration

• If indebtedness is part of consideration, ensure prescribed rates and proper payment terms are included

t February-8-12 47

Kiddie Tax

• Children taxed at top marginal rates on certain types of income

• Partnership freeze provides planning opportunity

• Example

t February-8-12 48

Kiddie Tax Example

Individual

Holding company

Portfolio of public company shares

Family

Trust

Minor Children

Beneficiaries

t February-8-12 49

Kiddie Tax

• If dividends are paid from private company to family trust and then allocated to children, kiddie tax will apply

• Income included in child’s income may reasonably be considered to be derived from provision of property in support of a business carried on by a corporation of which a person who is related to the individual is a specified shareholder

t February-8-12 50

Kiddie Tax - Partnership

• Investment portfolio held in a partnership

• Investment income “flows through” from public companies to family trust

• Provided that child’s parent is not a specified shareholder of public company, kiddie tax provisions will not apply

t February-8-12 51

Capital Gains Deduction

• Partnership may not claim, but gain retains identity

• Multiply access by holding QSBC shares through partnership

• QSBC definition provides for ownership by a partnership, provided partnership related to individual claiming deduction

• 110.6(14)(d) for purposes of QSBC definition, deemed related if member of partnership

• Permits direct sale of opco vs sale of holdco

t February-8-12 52

Foreign Issues

• Non-resident partners deemed carrying on business,

• Disposition of TCP retains identity

• Clearance certificates required

• Canadian partnership status not available if non-resident partners, will affect rollovers in and out of partnership

• Canadian partnership may conduct business outside of Canada

t February-8-12 53

US Estate Tax

• Partnership structures used to minimize US Estate tax

• Dramatic increase in usage, due to valuation discounts

• Recent cases have caused review by practitioners

• IRS attempts to “look-through” the partnership

• Possession and enjoyment

• IRS position evolving

• Proceed with caution

t February-8-12 54

Death of a Partner

• 70(5) deemed disposition at fair market value

• 70(6) rollover to spouse at acb

• 70(6)(d.1) no disposition if to spouse, prevents negative acb from being triggered

• Vested indefeasibly within 36 months

• 70(6.2) elect out of rollover to spouse

• Estate’s acb will equal amounts reported on terminal return

t February-8-12 55

Valuation

• Fixed value units

• Otherwise, based on underlying assets

• 70(5.3) amended in 2001

• Confirms that in valuing partnership interest, life insurance will be valued at cash surrender value, immediately before death

t February-8-12 56

Life Insurance Proceeds

• Corporation holds interest in partnership

• Partnership receives life insurance proceeds

• Addition to corporation CDA account at time partnership receives proceeds

• Life insurance proceeds added to acb of surviving partners’ interests, immediately after death

t February-8-12 57

Capital Loss Carry Back

• Estate disposes of partnership interest within one year of death

• Capital loss realized

• May elect to carry back to terminal return

• Planning for terminal return and estate usually driven by estate’s intentions

t February-8-12 58

Winding up after Death - Differences

• ACB of partnership interest reflect amounts reported on terminal return

• May have increased liquidity if life insurance received on death

• ACB of partnership interests will reflect life insurance proceeds received

• Value of interest may have changed for business issues

t February-8-12 59

Transfer to a Corporation

• 85(2) partnership transfers assets to taxable Canadian corporation on rollover basis

• Capital property that is real property may only be transferred if Canadian partnership

• Inventory of real property may not be transferred

• Consideration must include shares of corporation

t February-8-12 60

Subsection 85(3)

• Where assets are transferred pursuant to 85(2)

• Partnership wound up within 60 days

• Only asset is shares of corporation or money

• Intent is for tax deferred transfer of assets to partners

• Sometimes anomalies occur

• Cannot use multiple corporations, partners still together

• If conditions not met, taxable dissolution under 98(2)

t February-8-12 61

Transfer to Partners

• If want to be taxable, 98(2)

• If want to be tax-deferred, 98(3)

• One partner continues as proprietorship, 98(5)

t February-8-12 62

Subsection 98(2)

• Disposition of property from a partnership to a partner

• Deemed disposition at fair market value

• Partner deemed to have acquired at that value

• Watch “stop-loss” provisions

t February-8-12 63

Subsection 98(3)

• Elective rollover

• Canadian partnership

• All partners must jointly elect

• All partnership property must be distributed

t February-8-12 64

Subsection 98(3)

• Partners receive pro-rata undivided interest in each property

• Still not operating independently

• Consider “partitioning” under 248(20)

• If assets are shares, reorganize under 86

t February-8-12 65

Subsection 98(3)

• Similar to 85(3), anomalies can occur on tax deferred expectations

• Unlike 85(3), opportunity to “bump” certain property distributed to partners

• Capital property other than depreciable property

• Bump to acb of partnership interest, cannot exceed fmv of property

• Useful provision where acb of partnership interest increased on death of taxpayer

t February-8-12 66

Subsection 98(5), Partial Rollover

• One of former partners continues to carry on business as sole proprietor within three months

• Must be Canadian partnership

• Rollover only applies to property that continues to be used in proprietorship

• Assets not used will be deemed disposed at fmv under 98(2)

• Potential “bump”

• Does not require election

t February-8-12 67

Partnership Freeze

• Do not provide certainty of corporations

• May accomplish individual’s objectives

• Exposure to income reallocations

• Increased flexibility

• Planning opportunities

• Better integration

• Overall, in right circumstances, very useful tool

lifecycle of a partnership freeze - tax...

Documents