Tax planning approaches to consider in the sale of a business.
There is a myriad of reasons for deciding to sell your business — from retirement, to a new business opportunity, to an unsolicited offer. Whatever your reason for selling, it’s important to realize that the tax payable on the sale could be the largest one-time expense you will ever have to pay. Assuming you are planning an external sale and not transferring or selling the business to family members or management, there are a number of Canadian tax strategies you can consider. If you are a U.S. person, you should consult a qualified cross-border tax advisor to determine the U.S. tax implications of the following strategies.
Consider the following tax planning strategies, relevant to each of the four time periods associated with selling a business.
Note: Given the complexity of the following planning considerations, it is crucial to ensure your needs and circumstances have been properly accounted for by consulting with qualified tax and legal professionals.
If a sale is not imminent and you expect the value of the business to increase, then consider reorganizing the share ownership of your company such that some or all of the future capital gains of your business can accrue to other family member shareholders, either directly or through a family trust. This is commonly achieved by implementing an “estate freeze.” This strategy can allow for a multiplication of the lifetime capital gains exemption (LCGE) among family members on a future share sale of a qualifying small business corporation (QSBC). Every person has a lifetime LCGE on the sale of QSBC shares. To qualify, the family member must own the QSBC shares either directly or be a beneficiary of a family trust that owns the shares. The LCGE on the sale of QSBC shares is $848,252 for 2018 and indexed annually.
If shares are issued from treasury to family members or to a family trust, then the shares must be held for at least two years to qualify as QSBC shares and hence the LCGE, so advance planning in this case is important.
Other criteria that needs to be met in order to qualify for QSBC status are that throughout the 24-month period prior to the sale, at least 50 percent of the assets in the business must be used to carry on an active business in Canada, and at the time of sale, at least 90 percent of the assets must be used in the active business in Canada. If you have accumulated passive investment assets in your company, there may be strategies you can employ to restructure your business so the passive assets do not disqualify your shares from QSBC status and prevent you from claiming the maximum LCGE. It is easier to restructure your business in a tax-effective manner when there is no pending sale, so again, advance planning is important.
When reorganizing the structure of your business to qualify for the LCGE and also to multiply the LCGE with other family members, speak to your tax advisor to determine if you should “crystallize” your LCGE now. That is, even if you are not currently selling your business to a third party, some tax advisors may recommend that you crystallize your LCGE now, while the shares are QSBC shares, to avoid any concerns that the shares may not qualify for the exemption at some point in the future. However, depending on your situation, it may not be appropriate to crystallize the LCGE now, so investigate the pros and cons.
If the business is currently not incorporated but there is a prospective purchaser, then think about incorporating the business and selling the shares of the corporation in order to utilize your LCGE. In this case, the shares do not have to be held for at least two years to qualify for the LCGE.
Determine if the purchaser is interested in purchasing the assets of your business or the shares of your business. If they are interested in purchasing the assets of your business, then you will generally not be eligible to claim the LCGE. As a result, you might be able to negotiate a higher sale price so the after-tax proceeds of an asset sale are similar to a share sale.
There are some more sophisticated tax strategies that may allow you to claim both the LCGE for part of the proceeds as a QSBC share sale and treat the remaining proceeds as an asset sale.
If the purchaser is willing to purchase the shares of the business, then ensure that the shares qualify as QSBC shares in order to utilize any remaining LCGE. As previously mentioned, if there are passive assets in the corporation such that less than 90 percent of assets are being used in active business, your tax advisor may have to restructure or “purify” the business assets prior to sale to ensure that the business qualifies for the LCGE. However, if there is a pending sale, it may be more difficult to restructure the business on a tax-effective basis.
In addition to claiming the LCGE on a QSBC share sale, you may be able to effectively receive some of the sale proceeds tax-free into a holding company instead of paying tax currently at capital gains tax rates. This strategy is called a “safe-income strip.” You will need to speak to your tax advisor to determine if this strategy is available to you.
If the capital gains on the sale are expected to be substantial, speak to your tax advisor regarding other advanced tax strategies that can be considered to reduce and/or defer some of the tax associated with your capital gains.
Also consider having your advisor prepare a financial plan for you to determine if the expected after-tax sale proceeds will be adequate to enable you and your family to meet your retirement income and estate planning goals.
You may want to think about using some of the sale proceeds to make a charitable gift in the year of sale either directly to a registered charity or to your own charitable foundation. In order for this strategy to be effective, the charitable donation should be made before the end of the year in which the sale occurs (either December 31 in the case of an individual vendor or the fiscal year-end of the corporation for a corporate vendor). Since the donation is irrevocable, ensure that you have adequate other assets to meet your retirement income and estate planning goals. A financial plan can help in this regard.
Alternatively, if the purchaser is a Canadian public company, consider receiving some shares of the Canadian public company as part of the sale proceeds (these shares may be received on a rollover basis). The shares could then be donated in-kind to eliminate the capital gains tax relating to the donated shares and you would also receive a donation tax receipt equal to the market value of the stock donated, which can help reduce the tax on your cash proceeds.
In some cases, you may want to look at the pros and cons of setting up an Individual Pension Plan (IPP) or a Retirement Compensation Arrangement (RCA) in the year of sale, if you have not done that already. If the sale is structured as an asset sale, then the employer’s contribution to these retirement plans is considered a deduction to the corporation, which would reduce the corporate tax payable. Note that a more detailed analysis of the pros and cons of this should be performed given that income received from an IPP or an RCA in retirement is taxed as regular income. In comparison, tax payable today on an asset sale may be at lower tax rates (e.g. capital gain).
If you have publicly traded securities that are in a capital loss position, consider selling these loss securities prior to year-end to trigger the capital loss. This may help to reduce the capital gain on the sale of the business. This decision should be made based on investment merits as well. If you want to repurchase the stock, then you may want to wait 30 days to avoid the loss being disallowed under the “superficial loss” rules.
Another option might be to purchase flow-through shares prior to year-end to help reduce the tax relating to the sale of the business. Flow-through shares are resource-based investments where the government allows the purchase cost to be fully deducted against any other taxable income. However, the investments are more speculative in nature. Also, keep in mind that in some cases, there is an 18- to 24-month holding period.
Alternative Minimum Tax (AMT) may also apply on large personal flow-through purchases, so this should be discussed with your tax advisor before making a purchase.
Instead of receiving all of the sale proceeds in the year of sale, consider taking back a promissory note and having the purchaser pay the proceeds over a number of years, assuming you have an adequate guarantee of payment and an attractive interest rate on the note. In this case, a capital gain reserve may be taken to spread the capital gain on the sale over a maximum of five years. If your marginal tax rate is expected to be lower in the near future, the deferral of the capital gain can help minimize your overall tax on the capital gain.
If you expect to reinvest some or all of the sale proceeds in shares of another active Canadian business within 120 days after the year of sale, then you may be able to defer the recognition of some or all of the capital gain on the original sale.
Or, if you have publicly traded securities that are in a capital loss position, you could consider selling these loss securities prior to year-end to trigger the capital loss. If your current year capital losses exceed your current year capital gain, then the net capital loss can be carried back to offset capital gains in the prior three years. So, if you sold your business in 2018, then net capital losses in 2019, 2020 or 2021 can be carried back to 2018 to reduce the capital gain on the sale of your business and you would get a refund of some of the tax you paid in 2018 on the sale. This decision should be made based on investment merits and you should also bear in mind the 30-day superficial loss rules if you want to repurchase the security that was sold at a loss.
If you are going to work for the purchaser after the sale to assist with the transition, speak to your tax advisor to determine the best structure in which you should receive your compensation going forward — as an employee of the new corporation or a consultant. Also, work with a qualified investment professional to manage your sale proceeds to create adequate retirement income to meet your lifestyle needs.
You may also want to consider permanent life insurance to replenish any capital for the estate that was used to purchase a life annuity. This can also be a way to grow any surplus wealth that was realized from the sale in a tax-efficient manner to enhance your estate. If some of the sale proceeds are in a holding company, then life insurance can enable your beneficiaries to withdraw insurance proceeds from the holding company on a tax-free basis.
Lastly, don’t forget to talk to your legal advisor to determine if your Will may need an update in light of these changes.
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