Translation disclaimer
This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues: [TaxInterpretations translation]
1. The net income of a partnership in which A and B are partners is $5,000. This income is not high enough to cover the respective salaries of $40,000 and $20,000 per year that the partners pay each other before sharing the remaining profits or losses. What are the tax consequences of the above scenario?
2. If, immediately after the end of the year, the two partners dispose of their interest for $2,500, what are the tax consequences for each, given that they each invested $30,000?
Position:
1. The net income of the partnership attributable to its partners is $5,000. A and B will have to share this income according to the provisions of the partnership agreement in such circumstances. The amounts paid of $40,000 and $20,000 represent withdrawals and, consequently, the G.P.R. of A's interest will be reduced by $40,000 while that of B will be reduced by $20,000.
2. A will realize a capital gain of $10,000 and B will realize a capital loss of the same amount.
Reasons:
1. The CCRA's position is that salaries paid by a partnership to its partners are not deductible expenses of the partnership. Consequently, the amounts paid are considered to be withdrawals by the partners, which have the effect of reducing the adjusted cost base of each partner's interest. (IT-138R & 53(2)(c) ITA )
2. A's gain is explained by the proceeds of disposition of $2,500 less the negative ACB of $7,500 ($30,000 + $2,500 - $40,000) of its interest. B's loss results from the difference between the proceeds of disposition of $2,500 and the adjusted cost base of its interest of $12,500 (i.e. $30,000 + $2,500 - $20,000).
2001 ROUNDTABLE - QUEBEC CONFERENCE OF TECHNICAL ADVISORS
Question 27
Partnership - income allocation
Two individuals, A and B, formed a partnership. The partnership allocated its net income equally between the partners after first paying salaries of $40,000 to A and $20,000 to B.
One year, the partnership realized net income of $5,000 before paying salaries to its partners. In your opinion, sharing the income between the partners under the agreement would give the following result:
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A
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B
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Partnership
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Net income
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5,000
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Salary
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$40,000
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$20,000
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(60,000)
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Income sharing
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(27,500)
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($27,500)
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(55,000)
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Income/ (loss)
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12,500
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(7,500)
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Immediately after the end of the year, the two partners disposed of their respective interests for $2,500.
After reading opinion 1999-0011325 and the example presented in paragraph 11 of IT-138R - Computation and Flow-Through of Partnership Income, you are of the view that, according to the first document, the result would be that no loss would be allocable to B since the partnership has net income of $5,000, whereas, according to the second document, B would be able to claim the loss of $7,500. You are therefore asking us to explain the ambiguity that results from reading those two documents.
Response from the Income Tax Rulings Directorate
Paragraph 10 of IT-138R specifies that salaries paid by a partnership to its members do not constitute a business expense, but are a method of distributing partnership income among members. The income of a partnership in a taxation year may be less than the salaries which the partnership agreement requires to be paid to the partners. In this event, the excess of the salaries over such income appears as a deduction in the partners' capital accounts. Such a reduction of the capital of each partner is allowed as a deduction in determining the allocation to him of the income or loss of the partnership. Paragraph 11 of IT-138R provides an example of these calculations.
In our view, the comments and computations in paragraphs 10 and 11 of IT-138R issued January 29, 1979 are not accurate. In addition, all the adjustments that must be made in computing the adjusted cost base of partners' interests are not specified. We are currently studying the possibility of amending those comments, which should be done shortly in the publication Income Tax Technical News.
As we indicated in document 1999-0011325, we are of the view that the payment of salaries or any other remuneration to partners does not constitute a deductible expense by the partnership. Rather, it is an amount received by the partners as an allocation of their share of the profits or capital of the partnership. That amount therefore reduces the adjusted cost base of their partnership interest pursuant to subparagraph 53(2)(c)(v) of the Act. Furthermore, the partnership must allocate its income or loss (computed without taking into account the salaries or other wages paid to the partners) at the end of the taxation year.
Consequently, with reference to the above, the $60,000 salary expense paid to A and B is not deductible, with the result that the partnership realizes net income of $5,000 attributable to its partners at the end of the year. A and B may effectively be allocated an equal share of the entire business income (i.e. $5,000) from the partnership pursuant to paragraph 96(1)(f), to the extent that the partnership agreement specifies that this is the case. Where applicable, A and B must include business income of $2,500 in computing their income and the adjusted cost base of their interest in the partnership is increased by the same amount pursuant to subparagraph 53(1)(e)(i).
For its part, B cannot deduct a business loss of $7,500 from the partnership against B’s other income. All amounts received by A and B from the partnership will be considered as drawings. On the other hand, A and B do not have to include the amounts received from the partnership as employment income. The withdrawals of $40,000 and $20,000 made by partners A and B respectively represent adjustments to the adjusted cost base of their interest pursuant to subparagraph 53(2)(c)(v). Thus, in the example submitted, the adjusted cost base of the interests of A and B immediately after the end of the year would be as follows:
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A
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B
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Initial capital outlay
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$30,000
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$30,000
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Partnership income
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2,500
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2,500
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Withdrawals
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(40,000)
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(20,000)
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ACB of interest
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($7,500)
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$12,500)
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Because of the negative adjusted cost base of A's interest in the partnership, the application of subsection 40(3.1) should be verified.
When, immediately after the end of the year, the two partners dispose of their respective interests, A will realize a capital gain of $10,000 while B will incur a capital loss of the same amount. A's gain is explained by the proceeds of disposition of $2,500 less the negative adjusted cost base of his interest of $7,500, while B's loss results from the difference between the proceeds of disposition of $2,500 and the adjusted cost base of his interest of $12,500.
Nancy Deslandes
957-8961
2001-006606
May 10, 2001
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