I fully appreciate that different people have different goals. Some individuals want to retire outright; others want to leave a legacy. That said, small business owners across Canada have quite a lot in common – particularly those who are approaching retirement. Every retiring business owner holds one universal preference – upon retirement, they insist on leaving the CRA no more money than they have to. With that in mind, here are some guidelines on how to minimize tax on either the sale or generational transfer of a Canadian small business.
1) Utilize Your Lifetime Capital Gains Exemption
There are two ways a business owner can sell an incorporated business: via a share sale or via an asset sale. There are several nuances to both, but the key thing to consider when comparing the two is that buyers prefer asset sales, and sellers prefer share sales. One of the biggest reasons sellers prefer share sales is because the sale of qualifying small business shares in Canada can be exempt from capital gains tax (up to a prescribed limit). This exemption is known as the Lifetime Capital Gains Exemption (LCGE). As of 2016, the exemption limit is $824,176 of appreciation/gain (which equates to $412,088 of taxable gain). In other words, if a taxpayer sells the shares of a qualifying small business, the first $824,176 of appreciation/gain is tax exempt (the exemption limit is a unique number because it is indexed to inflation). As mentioned above, a small business must meet certain qualifying tests in order to achieve the exemption. The vast majority of incorporated, Canadian-owned small businesses that have carried on a principally active business for at least two years, here in Canada, will qualify. The message here is for retiring business owners to think long and hard (and to crunch the numbers) before considering an asset sale. Share sales (particularly those that qualify for the LCGE) are ideal, so it is advisable (and commonplace) to ask a higher price for the strict sale of a business’ assets, as opposed to the sale of a business’ shares.
2) Transfer Your Business to your Children Via an Estate Freeze
What about situations where retiring (or semi-retiring) small business owners want to pass their business on to their children? This can be accomplished in a few ways, but a common planning tool for these circumstances is an estate freeze. Simply explained, an estate freeze occurs when parents exchange the common shares that they hold in their business for preferred shares. This triggers a taxable ‘sale’ of the common shares, which (while taxable) can be offset by the parents’ LCGE (see above). Immediately following this exchange, the corporation would then issue new common shares to the sellers’ children. Because all of the business’ value is represented by the preferred shares issued to the parents, the value of the common shares issued to the children is zero. The resulting effect is twofold. Firstly, the children don’t have to pay anything for the new common shares (because they are being issued shares with nominal value). Secondly, all future growth in the company is attributed to the children, and will ultimately be taxed in their hands, as opposed to the parents’. All in, this is a much more efficient strategy than having the children purchase the shares from the parents outright (and/or for cash).
3) Other Measures
There are other, more complex planning strategies available to retiring business owners, including dividend stripping, amalgamations, using donation credits, etc. With that in mind, I should point out that more specific planning requires a more specific set of facts. To give some perspective, the CRA has introduced new legislation that limits the availability (and even prevents) dividend stripping. Furthermore, making a donation can of course offset taxes; however, you don’t want the tax tail to wag the investment dog. In other words, you never save more in taxes than you give away by donating, so this should only be used as a planning mechanism if a business owner plans to make a donation in any case. Starting, growing, and managing a small business is hard work, and I can also appreciate an owners’ hesitancy when making big decisions regarding the sale of their company(ies), which in many cases represents their life’s work. If you are considering the sale of your business, we can help. We offer financial counselling to small corporations, farmers, individuals with cross-border filing obligations, and several others. We would be happy to discuss your alternatives, and to come up with a plan that best suits your (and your family’s) needs and goals.
Personable and professional, Brent Soucie specializes in cross-border tax and financial planning for U.S. citizens and/or Green Card holders residing in Canada, as well as Canadian residents with U.S. employment and/or property. His clients include professional athletes, entrepreneurs, and corporate executives.