While corporations are the most common forms of business entities in Canada, operating partnerships with corporate partners are now becoming more prominent.

Partnership structures are attractive because they can be more flexible than corporate structures. Partnerships also tend to be subject to less comprehensive legislation and regulation than corporations. In addition, it’s often easier to introduce new partners, or for other partners to exit, than is the case with corporations and shareholders.

The use of corporate partners provides an element of creditor protection to individuals who participate in the business. And the introduction of a second tier of corporations can provide an additional element of protection to the principals in the business. In addition, tax savings can be achieved by utilizing this second tier of corporations to hold the shares of the corporate partners.

Staying within small business limit

For example, let’s assume Thomas, Norman and Theresa are arm’s length individuals, residing in Canada, who have established an active business through a partnership known as TNT. The business currently has a fair market value of $6 million ($2 million to each partner). TNT is owned equally by three corporations: Thomas Partner Inc., Norman Partner Inc., and Theresa Partner Inc. The three corporate partners are wholly owned, respectively, by Thomas Management Inc. (controlled by Thomas), Norman Management Inc. (controlled by Norman), and Theresa Management Inc. (controlled by Theresa). There are no significant corporate assets other than the partnership interests in TNT.

Assume that TNT earns $1.5 million of business income and allocates it equally to its corporate partners pursuant to the partnership agreement. Absent any other planning, the first $500,000 of income (the “small business limit”) would be taxed at a favourable rate (say 17%). The tax savings would be shared, presumably equally, by the three partners.

The remaining $1 million of income would be taxed at the higher corporate rate, in the range of 30% to 33% in most provinces.

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’s no requirement that the management companies share the small business limit. The management company and partner company, controlled by each individual, are entitled to their own small business limit, resulting in significant overall tax savings. In the above example, the entire $1.5 million of partnership income, if ultimately shared equally by the management companies, would be eligible for the small business rate. It is this feature that best explains the growing popularity of “tiered” partnership arrangements.

Such arrangements require careful tax planning from the clients’ advisors and should be fully documented.

Buy-sell structuring

The participating principals should also have a comprehensive partnership agreement that includes an insured, tax-effective buyout to be implemented on the death of Thomas, Norman or Theresa. One approach to fund a buy-out on death is for Thomas Management Inc., Norman Management Inc. and Theresa Management Inc. to purchase insurance on the lives of their respective shareholders. TNT would be the beneficiary of each policy, perhaps on an irrevocable basis so the designation could not be unilaterally changed. The face amount of each policy would be $2 million, reflecting the current fair market value of each partnership interest. As is the case with most shareholder agreements, the partnership agreement would exclude the amount of the insurance proceeds from the valuation.

On Thomas’s death, for example, TNT would receive the insurance proceeds payable under the policy owned by Thomas Management Inc. on Thomas’s life. Under the agreement, TNT would use the proceeds to purchase the partnership interest owned by Thomas Partner Inc. The tax consequences of this strategy would be as follows:

  • On Thomas’s death, he would be deemed to have disposed of his shares of Thomas Management Inc. for their fair market value of $2 million. Assuming an adjusted cost base (ACB) of zero, he would have a capital gain of $2 million unless the shares passed to Thomas’s spouse or a spouse trust. Tax on the capital gain, if applicable, would be approximately $460,000 (based on Ontario rates).
  • The life insurance proceeds would be received tax-free by TNT. 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 Thomas Partner Inc. would be entitled to all of the proceeds under the partnership agreement, the ACB of its interest in TNT would increase by the full $2 million.
  • On the “redemption” of its partnership interest, Thomas Partner Inc. would receive $2 million, the amount by which its ACB increased when the insurance proceeds were paid to TNT. Thus the payment would be tax-free to Thomas Partner Inc. as a return of capital.
  • If Thomas Partner Inc. had a pre-existing ACB in its units of TNT, the redemption of the units would result in a capital loss to the corporation. For example, a pre-existing ACB of $50,000 would increase to $2.05 million on payment of the insurance proceeds to TNT. The sale of the units for proceeds of $2 million would result in a net capital loss of $50,000. This could be applied against capital gains, if any, realized in the future.
  • Under CRA administrative practice, Thomas Partner Inc. would receive a credit to its capital dividend account (CDA) upon receipt of the payment from TNT. It would therefore have cash and a CDA credit of $2 million, and would have disposed of its partnership interest without tax consequences.

Following the above transactions, it would be open to Thomas Partner Inc. to pay a $2-million capital dividend in cash to its parent company, Thomas Management Inc. A variety of post mortem tax planning opportunities would at that point be available to the estate. A detailed discussion of these options is beyond the scope of this article, but here are two possible strategies:

  • If Thomas left his shares to a surviving spouse, they could be transferred to her on a tax-deferred basis. She would then be free to receive a $2 million capital dividend in cash from Thomas Management Inc
  • Alternatively, if Thomas did not have a surviving spouse, the insurance proceeds could be used to redeem some or all of the estate’s shares of Thomas Management Inc. This would create a deemed dividend in the estate, some or all of which could be declared as a capital dividend. However, because of certain “stop-loss” rules contained in the Income Tax Act, some tax would still be payable by Thomas or his estate. With appropriate planning, however, the redemption of shares using corporate-owned life insurance results in a lower level of tax than would otherwise be payable.

The two remaining corporate partners would be left with equal shares in a partnership worth $6 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 be used even if there is no second tier of corporations that hold shares in the corporate partners. The additional layer of corporations is relevant for optimizing the small business deduction, but not necessary for purposes of the insured buyout described above.


  • Glenn Stephens, LLB, TEP, PPI, is a Toronto-based lawyer and national director of professional advisory services for Equinox Financial Group. He is also author of Estate Planning With Life Insurance.