Note: Information updated in 2016.
Table of Contents
Summary
Tax planning prior to selling a business is one of the most valuable steps an owner can take to maximise net proceeds. Starting early allows business owners to take advantage of the lifetime capital gains exemption, which can shield up to $800,000 or more from tax on the sale of qualifying small business corporation shares. This post outlines key eligibility requirements, structuring strategies, and why engaging a tax lawyer or accountant years before a sale pays off.
Key Highlights
- Begin tax planning years before selling to maximise available exemptions and strategies
- Qualify for the lifetime capital gains exemption on small business corporation shares
- Understand the 24-month holding rule and active business asset requirements
- Multiply the exemption by including a spouse or children through a family trust
- Work with a tax lawyer and accountant to clean up non-qualifying corporate assets
In preparing to sell your business, the earlier the better applies. Some planning is best done years before:
- Start with an appraisal to determine the most probable selling price (MPSP);
- Identify drivers to increase the business’s value; and
- Get advice from a tax lawyer or accountant to take advantage of available opportunities for paying no more tax than necessary.
I have asked Jay Humphrey of Jay C. Humphrey Professional Corporation to comment upon one of the meaningful tax benefits available to owners of small businesses – the lifetime $800,000* capital gains exemption on the sale of shares of a qualifying small business corporation.
*Note: The LCGE for 2015 is $813,600; it is indexed for inflation, up to $1 million, for tax years after 2014.
Qualifying for lifetime capital gains exemption
While the tests for determining whether a sale of shares does or does not qualify for the exemption are technical, a rule of thumb is that the corporation must be operating an active, rather than passive, business and the assets owned by the corporation at the time of sale must generally be assets used in the active business.
A corporation’s stock portfolio acquired with retained earnings would typically be seen as “passive” assets, while inventory and equipment would be considered to be “active” assets. It is possible to clean up a non-qualifying corporation prior to the sale so that the seller can nonetheless qualify for the capital gains exemption.
“It is key to remember that only individuals (including as beneficiaries of certain trusts) can qualify for the exemption, notes Humphrey. “If there is a holding company between the operating company and the ultimate owner, the sale could only qualify if the individual sold shares of the holding company which in turn owns the operating corporation. The problem is that holding companies often hold passive or other assets that the business owner does not want to sell and that the buyers do not want to buy.”
“There are structures that may allow an owner to obtain the $800,000* exemption and also enjoy the benefits of a holding corporation, including creditor-proofing and the payment of tax-deferred corporate dividends out of the operating corporation. Business owners should speak with their advisers to see if such a structure is appropriate in their particular circumstances”.
Further requirements
There is usually a 24-month hold rule to claim the capital gains exemption, with a notable exception. An entrepreneur selling an unincorporated business may claim the lifetime $800,000* capital gains exemption on the sale of shares of a qualifying small business corporation by first transferring their business to a corporation and then selling their shares of that corporation.
*Note: For dispositions after 2013 of qualified small business corporation shares, the lifetime capital gains exemption limit was increased to $800,000 and indexed each year after for inflation.
A seller who accepts a promissory note for a portion of the purchase price payable over a number of years should be able to claim a capital gains reserve so that the timing of the obligation to pay income tax on the portion of proceeds not yet received is matched with the actual receipt of cash.
The capital gains reserve rules require a minimum of 20% of the capital gain to be recognized in the year of sale and the four following years. Keep in mind that the test in the reserve rules is not that an amount has not actually been received, but that it is not yet payable.
If the note that a vendor takes back is payable on demand without any restrictions, no reserve would be available as the Canadian Revenue Association (CRA) would argue the whole amount is immediately payable.
The new owner
From a buyer’s perspective, give careful consideration to using a newly incorporated corporation to acquire the shares of a target corporation. If you buy the founder’s shares which had an initial subscription cost of one hundred dollars, which is often the case, only that amount will be allowed to be repaid to you tax-free from the target corporation even though your cost to purchase the shares was their current market value.
“Using a new corporation to acquire the target should allow the tax-free removal of retained earnings of the target in amounts up to the purchase price through inter-corporate dividends to the new corporation and then a return of capital or debt to the owner of the new corporation,” said Humphrey.
Frequently asked questions
What is the lifetime capital gains exemption for small business owners in Canada?
The lifetime capital gains exemption (LCGE) allows qualifying individuals to shelter a significant portion of the capital gain on the sale of shares of a qualifying small business corporation from tax. As of 2015, the exemption was indexed to inflation up to $1 million. The business must operate an active business, and most assets must have been used in active business operations for the preceding 24 months.
How do I know if my corporation qualifies for the capital gains exemption?
To qualify, the corporation must be a Canadian-controlled private corporation operating an active business, with at least 90% of its assets used in an active business at the time of sale and at least 50% used in active business during the preceding 24 months. Passive assets such as investment portfolios or retained earnings in stocks may disqualify the corporation, but advance planning can often resolve this.
What is the 24-month hold rule when selling a business?
The 24-month hold rule generally requires that the shares being sold have been owned for at least 24 months before the sale to qualify for the lifetime capital gains exemption. There is a notable exception for unincorporated business owners who first transfer their business to a corporation and then sell shares. Consulting a tax specialist well in advance of a sale is strongly recommended to satisfy all qualifying conditions.
The Process of Selling a Business