Buy-Sell Agreements for Corporate Partnerships
The tax advantages of a tiered partnership
by Glenn Stephens & Kevin Wark, June 2008
While corporations are the most common form of business entity in Canada, operating partnerships with corporate partners are becoming more prominent. Tax savings can be achieved by using a second tier of corporations to hold the shares of the corporate partners.
MULTIPLYING THE SMALL BUSINESS DEDUCTION
By way of example, assume that Allan, Roland and Candice are arm's-length individuals, resident in Canada, who have established an active business through a partnership known as All Road Construction (ARC). The business currently has a fair market value of $3 million ($1 million to each partner). ARC is owned equally by three corporations: Allan Partner Inc.; Roland Partner Inc.; and Candice Partner Inc. In turn, the three corporate partners are wholly owned, respectively, by Allan Management Inc. (controlled by Allan), Roland Management Inc. (controlled by Roland) and Candice Management Inc. (controlled by Candice). For simplicity, it is assumed that there are no significant assets in the various companies other than the partnership interests in ARC.
Assume that ARC earns $1,200,000 and allocates it equally to its corporate partners pursuant to the partnership agreement. Absent any other planning, the first $400,000 of income (the "small business limit") would be taxed at a favourable rate (say, 17 per cent). The tax savings would be shared, presumably equally, by the three partners. The remaining $800,000 would be taxed at the higher corporate rate of approximately 33 per cent.
However, if each corporate partner pays its share of partnership income as a fee to its management company, which would thereby reduce the partner's income, there is no requirement that the latter companies share the small business limit. Each management company is entitled to its own small business limit, resulting in significant overall tax savings. It is this feature that has made these "tiered" partnership arrangements more popular.
The parties also need a comprehensive partnership agreement that includes an insured, tax-effective buyout to be implemented on the death of Allan, Roland or Candice. Under this arrangement, Allan Management Inc., Roland Management Inc. and Candice Management Inc. would purchase insurance on the lives of their respective shareholders. ARC would be the beneficiary of each policy, perhaps on an irrevocable basis so that the designation could not be unilaterally changed. The face amount of each policy would be $1 million, reflecting the current fair market value of each partnership interest.
On Allan's death, for example, ARC would receive the insurance proceeds payable under the policy owned by Allan Management Inc. on Allan's life. Under the agreement, ARC would use the proceeds to purchase the partnership interest owned by Allan Partner Inc. The tax consequences of this strategy would be as follows:
- On Allan's death, he would be deemed to have disposed of his shares of Allan Management Inc. for their fair market value of $1 million. Assuming an adjusted cost base (ACB) of zero, he would have a capital gain of $1 million unless the shares passed to Allan's spouse or a spousal trust. Tax on the capital gain, if applicable, would be approximately $230,000.
- The life insurance proceeds would be received tax-free by ARC. According to the act, each partner's share of the proceeds less the policy's ACB (assume this is zero) would be added to the ACB of its partnership interest. As Allan Partner Inc. would be entitled to all of the proceeds under the partnership agreement, the ACB of its interest in ARC would increase by the full $1 million.
- On the "redemption" of its partnership interest, Allan Partner Inc. would receive $1 million, the amount by which its ACB increased when the insurance proceeds were paid to ARC. Thus, the payment would be tax-free to Allan Partner Inc. as a return of capital.
- The CRA would also permit Allan Partner Inc. to receive a credit to its capital dividend account (CDA) upon receipt of the payment from ARC. It would, therefore, have cash and a CDA credit of $1 million and would have disposed of its partnership interest without tax consequences.
Following the above transactions, it would be open to Allan Partner Inc. to pay a $1 million capital dividend in cash to its parent company, Allan Management Inc. The latter company could in turn pay a capital dividend to its shareholders or use the funds to redeem shares owned by the estate.
The two remaining corporate partners would now have an equal share in a partnership that is worth $3 million without any corresponding increase in the ACB of their partnership interests. As such, this buy-sell structure merely shifts the capital gain (and resulting tax liability) into the hands of the two other corporate partners (and indirectly to their controlling shareholders).
It is noteworthy that this buyout structure can also be used even if there is no second tier of corporations that hold shares in the corporate partnerships. The additional layer of corporations is relevant for optimizing the small business deduction, but is not necessary for purposes of the insured buyout described above.
GLENN STEPHENS, LLB, and KEVIN WARK, LLB, CLU, TEP
This article was published in the December 2008 issue of FORUM magazine. Posted with permission from the Financial Advisors Association of Canada (Advocis).
These resources are provided for reference only and do not necessarily represent the opinions of Guilfoyle Financial Inc. Please consult your own tax and legal advisors.