Many lawyers and accountants operate using a limited liability partnership (“LLP”), and they own their interest in the LLP either personally or through a professional corporation. Today I’m going to explain what a partner’s capital account is, how it works, and why it matters.
How is partner’s capital in an LLP calculated
Generally, the starting point of a partner’s capital account is their initial contribution to the partnership. It is increased by their annual income allocation from the partnership and reduced by any accounting losses allocated to them and any draws that they took during the year.
A simple formula for calculating partner’s capital is:
Let’s say that in 2019 Tom recently became a partner of Black, White and Grey LLP and part of his requirements to join the partnership were to contribute a $100,000 capital loan in exchange for his partnership units. Although this loan is often tracked separately for accounting purposes, it is added to the balance in Tom’s partnership account.
BWGLLP’s partnership agreement calculates annual income allocations on an ‘eat what you kill’ model with allocations based on a mixture of professional time consumed and revenue earned. Because the partnership is successful and efficient, it has never incurred accounting losses.
Tom’s income allocations between 2019 and 2021 are as follows:
The partnership agreement requires that Tom leave his initial capital contribution in the partnership + $50,000 of working capital and increasing by $10k/year for every $100k that his income allocation grows to cover next year’s presumed increase in operating costs. Tom is entitled to withdraw the rest.
Tom’s draws between 2019 and 2021 are as follows:
Tom’s partner’s capital account is calculated as follows:
Initial capital contribution $100,000
Plus 2019 income allocation: $350,000
Less 2019 draws: ($300,000)
2019 partner’s capital: $150,000
Plus 2020 income allocation: $450,000
Less 2020 draws: $440,000)
2020 Partner’s capital $160,000
Plus 2022 income allocation: $600,000
Less 2021 draws: ($585,000)
2021 Partner’s capital $175,000
Tom’s partner’s capital balance of $175,000 represents the amount that is due to Tom for accounting purposes should he retire or leave the partnership.
For most people, you can stop reading here, the rest of this article focuses on the peculiar tax treatments of partner’s income allocations, ACB and ARA.
Tax allocations are not the same as draws nor accounting income allocations
To make matters more confusing, LLP’s track two different income allocations annually, and two different types of partner’s capital accounts, one for accounting and one for tax. The tax income allocation, ‘adjusted cost base’ and ‘at risk amount’ are tracked separately and reported to the partners on their annual T5013 slip. A T5013 slip is used to provide a partner with the information they need to file their taxes. Tax income allocations are determined in the partnership agreement, and often mirror the allocations of accounting income, but can vary widely depending on the particular business arrangement.
Accounting income vs taxable income
The accounting income, which contributes to the above noted partner’s capital account, is adjusted annually for items that are not deductible or must be included for tax purposes. The various adjustments that are made to accounting income to arrive at tax income are beyond the scope of this article, but everyone knows about a few: 1) 50% of meals and entertainment are not deductible for tax purposes (even though they’re included in accounting income), 2) golf dues are not deductible and 3) accounting depreciation on equipment is often different than tax depreciation.
Partner’s capital vs. Adjusted Cost Base (ACB – for tax) and the At Risk Amount (ARA – for tax)
The calculation of the Partner’s Capital Account and the ACB for tax purposes is approximately the same with a few main differences (and a few that are beyond the scope of this article): 1) as noted above, accounting and tax income and losses are generally different amounts and 2) Tax Income is not included in the calculation of ACB until the first day of the following year.
This second point can make limited partnerships problematic because if ACB goes negative, the partner must report the shortfall as a capital gain on their income taxes.
Back to Tom, let’s assume Tom was not a lawyer, but simply a silent partner in a regular limited partnership. In 2019 his tax ACB would be calculated as follows (let’s assume tax and accounting income are equal):
Initial capital contribution $100,000
Less 2019 draws: ($300,000)
2019 Negative ACB ($200,000)
January 1, 2020 – 2019 tax income: $350,000
January 1, 2020 ACB $150,000
In a typical limited partnership, Tom would have to report a capital gain of $200,000 on his personal taxes, in addition to his $350,000 income allocation. Tom can subsequently claim a capital loss and carry it back, mechanically this is a nightmare.
Fortunately for Limited Liability Partnerships, which are reserved for professionals, Canada’s tax act makes an exception and allows for ACB in such partnership to go negative without triggering a capital gain.
So that’s ACB, now onto ARA.
In Canada’s tax system there is a concept called the At Risk Amount or ARA. The ARA amount is in place to limit any particular partner from claiming partnership losses that might exceed their financial risk or “At Risk Amount” in the partnership. This is done because the concept of a limited partnership and a limited liability partnership is mean to limit any particular partner’s liabilities and so it would follow that they could not be allocated losses in excess of the amount which they’ve invested and are ‘at risk’ for in the partnership. The At-Risk Amount, said differently, is the amount of room for which that limited partner has to claim losses against. In most cases with lawyers and law firms, this number is rarely relevant as most of the law firms we deal with rarely run into losses.
Calculating ARA is very similar to calculating the tax ACB. In fact, the calculation starts with tax ACB and then adds in the current year income that may not hit the ACB calculation until the first day of the next fiscal year as discussed earlier.
So that’s a high-level overview of some of the most complex accounting and tax issues that lawyers face. Are you confused, you’re not alone, and that’s what great accountants are for – helping you understand the complex so you can take advantage of some of the perks in our tax system.
Of course as with anything in our tax system there is a lot more depth in topics like the partner’s capital account, Accounting vs. Tax income, Adjusted Cost Base, and At Risk Amount than the few minutes we’ve given it here, particularly with real estate developers and mining companies. Your situation may vary wildly from the topics we chatted about here, so make sure you check in with how ACB, ARA and partner’s capital accounts matter to you with your tax advisers. Of course, if you would like to get synced up with an accounting firm that handles LLPs and understands their intricacies.