One of the main benefits of setting up a private business is to eventually sell the business. Although many business owners have no immediate plans to sell, they should find comfort in knowing that with proper planning and execution, there can be a very rewarding prize at the end of the journey.
I encourage all business owners to consider their ‘exit plan’ strategy. For all the hard work and risk owners put in, there is a beautiful reward at the end of the tunnel, and that is the sale of the business.
It is helpful to have the mindset of an eventual sale as it will help guide decisions that build long-term value to the company. The more valuable the company, the more money an owner can expect to realize upon sale.
Now that we have established the benefit of building value and eventually selling one’s company, the next question becomes how can I setup my company as to minimize taxes upon sale?
How can I setup my company as to minimize taxes upon sale?
To answer this, I want to define a special rule that is available to individuals called the Lifetime Capital Gains Exemption (“LCGE”). Under the Income Tax Act, Canadian resident individuals can claim a lifetime capital gains exemption against taxable capital gains on the disposition of qualified small business corporation shares. The exemption is also available for dispositions of qualified farm or fishing property.
In 2017, for qualified small business corporation shares, the amount of the capital gains exemption was $835,716 and for qualified farm or fishing property, there was an additional exemption of $164,284. The capital gains deduction limit is half of these amounts as only 50% of capital gains are taxable.
As this capital gains exemption is a lifetime amount and non-utilized portions can be carried forward, in order to monitor the utilization of the capital gains exemption, every individual is required to file an income tax return for any year in which the individual disposes of property or realizes a taxable capital gain regardless of whether any tax is payable.
How much money can I save in taxes if I take advantage of the Lifetime Capital Gains Exemption?
In 2017, the highest combined (federal and provincial) tax bracket in Ontario was approximately 53.53%. If the capital gains exemption was never utilized by the individual, the individual was in the highest tax bracket and the individual was able to use the full capital gains exemption on eligible shares, the tax savings would be about $223,679 (=$835,716 x 50% x 53.53%)
What are the criteria?
In order to qualify, the individual must dispose of shares they have in a Qualified Small Business Corporation (“QSBC”). A QSBC share is a share in the capital stock of a corporation that meets the following three tests:
1) Small Business Corporation Test – At the time of sale, the share was capital stock of a small business corporation, and it was owned by you, your spouse or common-law partner, or a partnership of which you were a member.
A small business corporation is a Canadian controlled private corporation (CCPC) in which all or substantially (90% or more) of the fair market value of the assets were attributable to assets that were either used principally in an active business carried on primarily (more than 50%) in Canada by the corporation or a related corporation
2) Holding Period Asset Test – Throughout the 24 months immediately before the shares were disposed of, the shares were not owned by anyone other than the individual, spouse, common-law partner or related partnership, and it was a share of a CCPC and more than 50% of the fair market value of the assets of the corporation were a) used mainly in an active business carried on primarily in Canada by the CCPC, or by a related corporation b) certain shares or debts of connected corporations or c) a combination of these two types of assets
3) Holding Period Test– Throughout the 24 months immediately before the shares were disposed of, no one owned the shares other than you, a partnership of which you were a member, or a person related to you.
There are some finer details with the above rules, but this is the general framework. If any of these criteria are not met, then the shareholder would not be eligible for the capital gains exemption. Therefore, it is very important that a company and it’s balance sheet is monitored as to ensure the above criteria are being met.
What tax tips can be used so the criteria above can be met?
A common tax tip relating to the lifetime capitals gains exemption is purification. When assets do not meet the 90% threshold for the small business corporation test, shareholders can attempt to purify their assets. Purifying means adjusting the mix of active and passive assets. By re-characterizing or removing passive assets, the mix of assets is re-proportioned to meet the 90/10 ratio of active to passive investments.
It is very beneficial to qualify for the capital gains exemption but this topic can be complicated. I suggest seeking out professional guidance prior to selling shares within your business.
Disclaimer – The information contained in this article is for information purposes only. It does not provide legal or accounting advise and it should not be relied upon. All tax situations are unique to their facts and will differ from the situations in this article.