How do owners in a partnership earn income?

Question

I am 1 of 2 partners (no employees) in a recently registered consulting business. Essentially we are 2 former sole proprietors joining forces. We are currently working on forming our partnership agreement with a lawyer.

Could someone explain to me, at a high level, how partners earn income from a partnership and the tax implications?

BACKGROUND: As a sole-proprietor, I simply charged my clients HOURLY RATE + HST and the amount that I invoiced (minus HST and expenses) was my income.

With 2 partners, working variable hours for different clients, bringing funds into the partnership, do we pay ourselves a "salary" or do we simply draw the funds (in accordance with the partnership agreement) and that becomes our income? The thing that confuses me is that the partnership is not a taxable entity, so that makes me think the $ is considered our taxable income as soon as it enters the books of the business.

I will of course be consulting a professional accountant on this, but would very much appreciate to have a better understanding of the workings myself.

Answer 1

The partnership agrees to pay each of you salaries and/or bonuses, typically based on the net profit brought in. You do have a legal document setting out the rules for this partnership, right? If so, the exact answer should be in there. If you don't or it isn't, you need a lawyer yesterday.

Answer 2

If you business is incorporated, it's up to the two of you how to do it. Typically, you will have the company write cheques (or make transfers, whatever) to each of the humans:

• as a salary, which for convenience is typically a fixed amount each month
• as bonuses, which are easy to vary and can also have a tax-deferral component
• as dividends, which are in proportion to shares owned and may have a preferential tax treatment

If you want to say that each of you gets a salary of 80% of the revenue you bring in, and then tweak things with bonuses, you can. If one of you is contributing more to marketing and awareness and less to revenue, then you may prefer to pay you each the same even though the revenue you bring are different. It's up to you - it's quite literally your business.

When you're not incorporated, then for tax purposes you split the income and the expenses according to your ownership share. If that doesn't seem fair to you, then a partnership is probably not as useful to you as being incorporated. In general, it's better to be incorporated once you're past any initial phase in which the business is losing money for tax purposes (acquiring depreciable assets) and the partners have taxable income from elsewhere (day jobs, or at least income from the earlier part of the year before starting the business.)

I would recommend that the "partnership" phase of the business be very short. Get incorporated and get a shareholder agreement.