The Canadian business landscape is dominated by three formats. A sole proprietorship is a single-person, unincorporated business. Corporations, the second type of arrangement, are the best known. The third kind, however, is common, but often misunderstood. It is the partnership.
There are a few characteristics of partnerships that are not widely known or fully appreciated. All stem from legislation and the inherent legal nature of a partnership. All can have a major impact on its partners.
1. The “deeming” provision
Although a partnership can be created by a written agreement, such a contract is not necessary for a partnership to exist. Under Saskatchewan’s Partnership Act (the “Act”), as in most Canadian provinces, a partnership exists whenever there are “two or more persons carrying on business in common with a view to a profit”. A court may deem someone to be a partner, whether or not that person intended to act as a partner. All that is required is an intention to participate in a relationship that satisfies the Act’s definition.
The Act defines “business” as every trade, occupation or profession, which could conceivably include any kind of commercial activity. However, the business must be carried on “in common”, suggesting some type of mutual control and involvement in the business. Relationships such as employer-employee and debtor-creditor are not considered partnerships. The last part of the definition, “a view to a profit”, means that the business must be profit-oriented (note that whether or not profits are actually made is irrelevant).
Some common characteristics of a partnership (in the absence of evidence to the contrary) include: sharing of profits, sharing in the control or management of the business, contribution of capital and joint ownership of property. Co-ownership does not by itself create a partnership; however, if co-owners manage a business of buying and selling properties and sharing in profits, such a relationship could result.
2. The nature of a partnership
A common misconception about partnerships is that they are legal entities – not a surprising belief, since most partnerships operate under a “firm” name. A partnership, however, is merely a legal relationship between the individuals composing it. Unlike a corporation, it has no legal existence on its own.
This has several consequences, and is why the deeming provision is so important. First, the profits, debts and liabilities of the business are not dealt with at the partnership level. They are distributed among and borne by the individual partners. Second, each partner is an agent of the firm and the other partners. This means the partners are jointly responsible to third parties for liabilities incurred by any partner in the ordinary course of business. Third, while income is calculated at the firm level, the partnership is not taxed at the firm level. Income or losses are allocated out to the partners and are included in the individual tax returns of the partners.
One benefit of the partnership structure is that a partner can deduct losses from the business against income from other sources. This is often exploited in “flow-through” investment schemes to reduce investor taxes. The downside is that there are liability risks, usually much higher than in a corporation. For example, it may not be advisable to enter into partnership with individuals who have significantly fewer assets than you do. If your firm suffers a loss, and your partners have little or no financial resources, creditors will look for the deepest pockets. This could put you on the hook to the full extent of your personal assets to cover the debts of the business.
Since a partnership can be created without conscious effort, a formal agreement is not mandatory. Put another way, a partnership exists automatically whenever two or more people carry on business in common with a view to a profit. Sometimes the partners will do this with full knowledge of the consequences. Other times, it just happens, and when a partnership results, there may not have been any consideration of a contract.
The Act creates a default partnership agreement, in case the partners have not. In summary form, these default provisions are:
• All losses and profits are shared equally between the partners;
• Each partner is to be indemnified for expenses and liabilities incurred in the ordinary course of business and in the preservation of the business;
• All partners are entitled to take part in the management of the business;
• No partner may be an employee of the business – that is, no partner is entitled to remuneration for acting in the business;
• All partners must consent before any new person can become a partner;
• Ordinary matters are to be settled by majority vote;
• All partners must consent to a change in the nature of the business;
• A majority of the partners cannot expel another partner;
• The partnership is dissolved:
1. If entered into for a fixed term, by the end that term;
2. If entered into for a single venture, by the termination of that venture;
3. If entered into for an undefined time, by any partner giving notice to the other partners of his or her intention to dissolve the partnership;
4. Upon the death or bankruptcy of any partner;
These may not be what the parties intended (assuming they intended to form a partnership in the first place). For example, the partners might have assumed that one person will handle day to day management matters. More seriously, if there are 3 or more partners, it is often the intention that the death of a partner will not terminate the partnership among the survivors. An automatic termination, such as the Act provides, can create extreme tax issues.
The Act’s default provisions can only be altered by entering into a partnership agreement. This agreement does not have to be in writing, but because verbal contracts are so difficult to prove, it is highly recommended to have a written agreement. Such an agreement should be considered if any of the Act’s default provisions do not reflect the partners’ desires or intentions.
Common provisions of partnership agreements provide for unequal distribution of profits and losses, allocate management responsibilities based on the contributions of each partner and prevent the Act’s deemed dissolution. Also important are indemnification provisions, which might state that any partner who acts in contravention of the agreement shall indemnify the other partners for any losses or claims that result, or might give a partner a lien on the business interests of the offending partner.
None of these issues should scare people away from using partnerships. They are extraordinarily useful and flexible, and are used by large and small ventures alike. Unlike a corporation, however, they can be created accidentally. As long as the consequences are kept in mind when setting up a business, they can be an invaluable tool.