By Kody Wilson, GGFL
For many business owners, the sale of their business can represent the largest influx of cash they will ever receive and often serves as their retirement fund once they decide to exit the business. If done properly, the sale of the business can provide wealth for the owner and the next generation. Careful planning must be considered to maximize value and minimize taxes. This chapter discusses different strategies for restructuring your business to optimize its tax efficiency prior to the sale as well as examining some of the tax implications to plan for on a sale of a business.
Lifetime Capital Gains Exemption
A major tax advantage allowed by the Canadian government is the use of the lifetime capital gains exemption for the sale of shares in a privately owned Canadian company. This exemption can allow each shareholder of a business to exempt up to $971,000 (as of January 1, 2023) of sale proceeds from income tax. Based on the taxes otherwise payable on the sale of shares, this represents a tax savings of approximately $260,000. This amount in the shareholder’s pocket can go a long way in retirement. Every business owner should do all they can to ensure their private company qualifies for this advantage.
The Income Tax Act (ITA) includes extensive rules that deal with the shareholder’s ability to use the exemption on the sale of their shares. For practical purposes, be aware of the following key rules:
- The company is a Canadian controlled private corporation
- Shares of the company must be held for 24 months prior to sale (think of this as the anti-flipping rule)
- 90% of the assets must be used in the business at the time of the sale
- 50% of the assets must be used in the business at every point in time for 24 months prior to the sale
Ongoing planning is important to ensure a shareholder(s) is not offside with these rules leading up to a sale. This is an all-or-nothing test; there is no partial exemption if you do not meet some of the tests. Given the strict test requirements and the potential tax savings, business owners should regularly discuss their exit strategy with their advisors as pre-sale planning may be required.
Asset Sale vs. Share Sale
Once the owner has decided to sell the business, there are basically two options: sell the company’s shares or sell the business’ underlying assets. Each option has its pros and cons (see below); the buyer and seller may prefer and be motivated by different options. As this is often the case, gaps may be bridged in a potential deal through various means (e.g., price adjustments, hybrid sales, earn-outs, payment structure).
A sale of shares involves selling the entire business, including all assets and liabilities whether or not they are used in the business. For example, the corporation may have real estate, investments, shares of other private companies, and so on that the vendor may not want to sell and the purchaser may not want to buy. A sale of shares also involves the purchaser taking over the company and any skeletons in the closet (i.e., unknown liabilities) that may exist since the company was set up. Indemnities in sales agreements can help mitigate these issues but it is still worth mentioning. The share option can present some advantages for a buyer in the form of retaining the brand recognition, reputation, and goodwill of the business being acquired.
From a tax standpoint, based on what we learned about the sale of shares and the capital gains exemption, a vendor often hopes for a share sale to be able to use the capital gains exemption. Over and above the capital gains exemption on a share sale, the remainder of the sale proceeds would be taxed as a capital gain to the selling shareholder at the 50% inclusion rate (total tax rate of 27% at the top rate in Ontario). This personal tax rate on a share sale is generally more favourable to the vendor than an asset sale.
There is no exemption from tax on an asset sale; each asset sold would be taxed in the company the vendor is retaining. While the tax paid on an asset sale is more complicated, there are two types of taxes that can arise:
- Recapture of previously claimed capital cost allowance on capital assets, taxed at the company’s normal rate
- Capital gains tax for the difference between what the company paid for an asset and what they are selling it for
On top of this tax in the company on the asset sale, the shareholder would also be taxed personally when they ultimately withdraw the sale proceeds from the company. The shareholder may either withdraw the sale proceeds from the company at the time of the sale or invest the funds in the company for future withdrawal. The vendor is still responsible for paying off all corporate debts of the cororation, as buyers generally don’t assume all liabilities on an asset sale, as they would on a share sale.
Asset sales and share sales both have appealing characteristics. This is not unusual and, if both parties have the appetite for a more complex transaction, they may pursue a hybrid deal. Put simply, this would involve a partial share purchase and a partial asset purchase in the same transaction. Significant planning and pre-closing transactions can be required to achieve this outcome but it can be worth it under specific circumstances for both parties to reap the benefits of both worlds.
Family and Trust Planning
Given the potential magnitude of the capital gains exemption, where possible, business owners may want to allow other family members the opportunity to use the exemption on the sale of the family business. For the business owner’s spouse or child to use the exemption, they must directly hold shares in the private company. Put simply, if everyone in the family held shares, they would all have the potential to use the exemption on a share sale. That is a lot of potential share sale proceeds that could be exempt from tax for a family.
While there is a significant tax advantage of family members directly owning shares in the business, it might not be a practical or desirable scenario for various tax, legal, and other reasons. One possible remedy is to have a discretionary family trust own some or all common shares in the business. This technique affords the business owner the best of both worlds, as family members do not need to hold shares directly and some of the capital gains exemption could be allocated to them through the family trust on a sale.
It can be complex to set up a trust as a shareholder of a private business. However, given its significant benefits, business owners should consider this an option.
Bill C-208 Planning
There have been some exciting developments from Finance Canada recently, commonly referred to as Bill C-208 planning. The bill introduced new tax legislation that opens the ability to use the lifetime capital gains exemption on a sale of shares from a parent to an adult child or grandchild provided that certain explicit conditions are met. This will allow more business owners to pass their business to the next generation in a tax-efficient manner. Careful consideration of the rules is required for these potential transactions. For example, it requires the business owner to employ an arm’s length party to provide a valuation for the planning to be valid and the capital gains exemption to be available.
As can be seen from the discussion above, careful planning is paramount to ensuring the after tax proceeds on a sale are maximized. Although business owners are often focused on the ultimate selling price, the structure of the deal and the possible restructuring of the business before a sale can be just as important in terms of the after tax dollars left in the business owners’ hands.