Winding up a partnership: Minimizing the tax effect

Partnerships, and in particular limited partnerships, are often used as effective and flexible investment structures to attract both current and future investors. Given the attractive tax benefits of being part of a flow-through entity, understanding when and how to form and dissolve a partnership in a structure is invaluable knowledge.

Tips and traps

Specifically, there are certain nuances to consider both when transferring assets into a partnership and when dissolving a partnership. Most notably, when transferring or contributing assets to a partnership, taxpayers need to be mindful of subsection 97(1) of Canada’s Income Tax Act,¹ which states that (after 1971) a partnership that has acquired property from a taxpayer who is also a member of the partnership is deemed to have acquired the property at an amount equal to its fair market value (FMV). In certain circumstances, taxpayers may defer their capital gains when transferring property to the partnership by electing under subsection 97(2).

On the flip side, when transferring assets out of a partnership, subsection 98(2) is the general rule followed; it states that any property distributed to a partner results in a disposition at FMV. As a result, planning may be required to avoid triggering any accrued unrealized gains or recaptures for income tax purposes.

The following are the four most common techniques to minimize the tax effect of winding up a partnership:

1. Distribution without planning at FMV

   If there are nominal assets within the partnership or if the liabilities are in excess of the FMV of the assets, typically the tax result from the deemed disposition of assets within the partnership will be manageable. As a result, in such cases it is sensible to pay the tax, if any. This is the most cost-effective solution from a tax-planning perspective, as it doesn’t require as much planning or oversight.

2. Pro rata distribution of assets to all limited partners

   A deemed disposition at FMV can trigger punitive tax liabilities when the partnership holds assets with large accrued gains. This is especially problematic when either the partners or the partnership do not hold sufficient liquid assets, as the wind-up may force them to sell non-liquid assets. To avoid these types of scenarios—assuming the partnership agreement allows for it—the partnership may arrange to distribute all of its assets on a pro-rata basis to each of its members under subsection 98(3).

   This option is often the preferred choice if the partnership holds assets with accrued gains and there is no succession planned for the partnership business. It is important to note, however, that only Canadian partnerships² may elect under subsection 98(3) and each partner must receive a pro-rata entitlement of every other partner’s interest; for instance, in a scenario where a partnership has two $1.00 coins, two equal partners would each receive one half of the first coin and one half of the second coin instead of one coin apiece. To avoid a punitive tax result when undertaking this kind of election, it may be advisable to rely on the partitioning rules under subsections 248(20) and 248(21).

   It’s also vital to review the partnership agreement to confirm that it allows for this type of election and distribution to be made; if it doesn’t, partnership agreements can be amended, in practice, to include additional clauses that allow for this type of distribution. If some members don’t want to participate in the election, they can either sell their partnership interests or receive a final distribution prior to the dissolution. Lastly, it should be noted that any partner electing under subsection 98(3) may still realize a capital gain if the pro-rata share of the assets’ tax cost they receive is higher than the adjusted cost base (ACB)³ of their interest in the partnership; however, due to the minimum proceeds being higher than the ACB, they would not be able to realize a capital loss.

3. Distribution of assets to one partner

   If a Canadian partnership is looking to distribute all of its operations to one member in the future (the continuing member), it may be advisable to follow the criteria under subsection 98(5), as this would allow for a similar tax-deferred wind-up as subsection 98(3) (see technique #2) without requiring the partnership to fill out a prescribed tax election form.

   One common scenario is when a partner looks to purchase and consolidate all of the partnership’s interests with the ultimate goal of winding up the partnership and continuing the business themselves. Assets then transferred to this partner would be deemed to be transferred at cost, and the realization of gains would be deferred as a result. Something to watch out for here is if assets are transferred to members other than the continuing partner, as these transfers would not be tax-deferred.

   Another common scenario is when all of the members of the partnership prefer to continue the partnership business through a corporation. In such cases, they may consider electing under subsection 85(1) to transfer all of their partnership interests into a newly incorporated corporation; they could then rely on subsection 98(5) to roll its assets into this corporation on a tax-deferred basis.

   Another strategy partners often employ to pass the partnership business on to a corporation is to first elect under subsection 85(2) to transfer the partnership assets into a newly incorporated corporation; they can then rely on subsection 85(3) to wind up the partnership on a tax-deferred basis. While this option is sometimes simpler as it doesn’t require each member of the partnership to transfer their partnership interest into a new corporation, subsection 85(2) has similar limitations as subsection 85(1) when it comes to transferring certain assets. The advantage of using this method is that the transferor partnership does not need to be a Canadian partnership.

4. Merging partnerships

   To simplify structures, a merging of partnerships is sometimes warranted. Unfortunately, there are no amalgamation provisions for partnerships in the ITA, so appropriate steps need to be taken to achieve a similar tax deferral. One approach would be to elect under subsection 98(3) and distribute assets on a pro-rata basis to each of the partnership’s members. The members could then roll the partnership assets into a new partnership on a tax-deferred basis.

   Another option would be to roll the partnership itself into a new partnership under subsection 97(2). The old partnership could then elect under subsection 98(3) and distribute the new partnership interest to each member, keeping in mind the pro-rata interest concerns mentioned earlier.

Seek advice

As this article demonstrates, the process of winding up a partnership can be complex. To minimize the tax impact, taxpayers would be wise to seek advice from a trusted and knowledgeable tax professional before proceeding.

Tino Chou, CPA, is a senior manager in tax with MNP in Vancouver, specializing in a wide variety of sectors, including real estate, technology, consumer goods, and the hospitality industry. He also advises clients on acquisitions and divestitures and succession-planning transactions.

This article was originally published in the March/April 2024 issue of CPABC in Focus.

Footnotes