Partnerships: How Income Splitting Works in an Unincorporated Business – A Complete Guide by a Montreal CPA Firm Near You

Introduction
Partnerships are one of the most flexible business structures for freelancers and small
business owners in Canada who want to share profits, split responsibilities, and reduce
individual tax burdens. However, many Canadians enter partnerships informally—with
no written agreement—and later face CRA issues when profits or losses are allocated
incorrectly. Unlike corporations, unincorporated partnerships do not pay tax themselves.
Instead, each partner reports their share of income or loss on their personal return. This
provides opportunities for income splitting, but also creates significant compliance
obligations. Understanding how profit allocation works in a Canadian partnership is
essential for avoiding disputes, CRA reassessments, and incorrect filings. This guide
explains how partnerships are taxed, how income splitting works legally, how to report
partnership income, and the documentation CRA expects.
Legal and Regulatory Framework
Partnership taxation in Canada is governed by the Income Tax Act, common law
partnership principles, and provincial Partnership Acts (e.g., Québec’s Civil Code,
Ontario Partnership Act). Key rules include:
• A partnership exists when two or more persons carry on business in common with
a view to profit.
• A partnership may be formed formally (written agreement) or informally (oral
agreement or conduct).
• A partnership itself does not pay income tax.
• Each partner reports their share of net income or loss on Form T2125, or on a T5013
slip for large partnerships.
• Profit or loss must be allocated according to the partnership agreement, or equally if
no agreement exists.
• Partners must include their share of income whether withdrawn or not (accrual
basis).
• Partners are responsible for their own CPP contributions on partnership income.
• Partnerships must keep proper records, including invoices, contracts, capital
contributions, and expense allocations.
These rules form the legal basis for partnership income splitting in unincorporated
businesses.
Key Court Decisions
Several important cases shape CRA’s interpretation of partnership allocations:

1. Continental Bank Leasing Corp. v. Canada

The Supreme Court clarified what constitutes a valid partnership: intention, contribution,
mutual control, profit-sharing, and business carried on in common.
2. Backman v. Canada
The Supreme Court emphasized that a partnership must have a legitimate business
purpose, not simply tax planning. Income splitting is allowed only when a real
partnership exists.
3. Spire Freezers v. Canada
The Court reinforced that profit allocations must reflect the partners’ agreement, not
arbitrary amounts designed only to reduce taxes.
4. Morrison v. Canada
CRA successfully denied a spouse’s share of partnership income because she made no
contribution of capital, labour, or risk. The court treated it as an artificial income split.
These rulings show that CRA verifies both substance and form when evaluating
partnership income splitting.
Why CRA Targets This Issue
Partnerships are heavily scrutinized by CRA because they are commonly used for
informal income splitting. CRA focuses on:
• partnerships between spouses or family members where one partner contributes little
or no work
• arbitrary profit splits (e.g., 90/10) without justification
• undocumented or missing partnership agreements
• losses allocated disproportionately for tax advantage
• inconsistent reporting between partners’ tax returns
• partnerships with unclear ownership of assets or inventory
• large expenses deducted by partnerships without individual records
CRA routinely reassesses partnerships that appear artificial, lack business purpose, or
fail to demonstrate that both partners contribute labour, capital, skill, or risk.
Mackisen Strategy
At Mackisen CPA Montreal, we help entrepreneurs structure partnerships correctly to
maximize income splitting while staying fully compliant with CRA rules. Our structured
partnership strategy includes:
• determining whether a legitimate partnership exists under tax law
• drafting or reviewing partnership agreements defining:

– capital contributions
– labour contributions
– profit-sharing ratios
– loss allocation
– dispute resolution mechanisms
• ensuring allocations reflect economic reality, not artificial tax motives
• setting up proper bookkeeping for partnership income and expenses
• preparing Form T2125 or T5013 allocations for each partner
• analysing GST/HST registration requirements for partnerships
• implementing a documentation system to prove each partner’s involvement
• planning long-term strategies for income splitting and potential incorporation
This ensures that your partnership is both tax-efficient and CRA-compliant.
Real Client Experience
A graphic design partnership between two friends split profits 50/50, but one partner
handled 80% of the work. CRA questioned the allocation during a review. We
documented each partner’s role and adjusted the agreement to reflect labour
contributions, preventing reassessment.
Another client operated a husband-and-wife partnership in a home-based business.
CRA challenged the wife’s 60% share. We demonstrated her role in administration,
marketing, and service delivery, allowing the allocation to stand.
A third client ran a short-term Airbnb rental as a partnership but kept no records of
expenses or responsibilities. CRA denied several deductions. We reconstructed records
and established a formal agreement, avoiding penalties in future years.
Common Questions
Self-employed taxpayers often ask whether spouses can form partnerships. Yes—if
both contribute meaningfully to the business.
Others ask whether profits can be split arbitrarily. Only if it reflects real business
contributions and is documented.
Some ask whether they need a written agreement. Strongly recommended—without
one, CRA defaults to equal allocation.
Another question: Do partners file separate T2125s? Yes—each partner reports their
share individually.
Why Mackisen
With more than 35 years of combined CPA experience, Mackisen CPA Montreal helps
self-employed partnerships structure their agreements, allocate income correctly, and

stay fully CRA-compliant. Whether you are forming a new partnership or correcting an
existing one, our experts ensure precision, documentation, and tax efficiency.