Tax considerations when selling your business
By ATB Wealth 8 April 2020 6 min read
It’s important to recognize the significant impact taxes can have on the proceeds realized from the sale of a business. In this article, we highlight some of the tax considerations that may be relevant for vendors. Involving an experienced tax advisor well in advance of the sale can help business owners achieve the maximum after-tax result.
Asset vs. share sale
It will generally be to the vendor’s advantage to structure the sale of their business as a share sale. Where the fair market value of the shares sold is in excess of the cost, the vendor will realize a capital gain. A share sale may allow the vendor the opportunity to utilize the capital gains exemption (discussed further below) or unused capital losses.
In contrast, where the sale of the business is structured as an asset sale, the vendor will continue to have two potential levels of tax. Corporate tax may result from the sale of the assets to the purchaser and personal taxes may result when the funds are withdrawn from the corporation. The vendor will have an ongoing obligation to file corporate tax returns unless the corporation is wound-up.
Understanding the bias of potential purchasers will also be helpful to vendors in the negotiation process. Purchasers will generally have a preference to purchase the assets of a business rather than shares. Where assets have appreciated in value (or even maintained the original value that has been partially depreciated), the purchaser will benefit from larger tax deductions in future years where the business is acquired in an asset transaction. The purchaser may also be more comfortable from a risk perspective in acquiring assets in that the existing liabilities of the corporation will remain with the vendor.
A key takeaway is to recognize that a $1,000,000 offer to purchase the assets of a business, for example, is unlikely to represent the same after-tax result as a $1,000,000 offer to purchase the company’s shares. If a purchaser proposes an asset transaction, the tax cost to the vendor should be considered in the negotiation. The option for a hybrid transaction (combining elements of both asset and share transactions) may also exist.
Capital gains exemption
The lifetime capital gains exemption (LCGE) is available to individuals that dispose of qualified small business corporation (QSBC) shares with an exemption limit of $883,384 per individual in 2020. For taxpayers in the top marginal tax bracket in Alberta, this represents tax savings of approximately $210,000. In order to qualify, three tests must be met: determination time test, holding period test and nature of assets test. Generally speaking, this means that:
- Ninety per cent of the fair market value of the assets in the corporation must be used in active business in Canada at the time the shares are sold;
- The shares must have been held by the individual or a related person for 24 months; and
- During the 24 month period, 50% of the fair market value of the assets in the corporation must have been used in active business in Canada.
The two year time period for the QSBC criteria is just one reason to consider engaging a tax advisor in business succession discussions well in advance of a sale. A tax advisor can assist in determining whether a company’s shares are QSBC shares. Where the active business assets do not currently meet the required thresholds, strategies can be considered to increase the active business asset percentage (commonly referred to as “purification”).
Some purification strategies include: selling passive assets and using excess cash to reduce debt or to purchase additional active business assets. Purification can also have non-tax benefits in that redundant assets that a buyer may not want to acquire are removed from the corporation prior to sale. There may also be an opportunity to access multiple capital gains exemptions where other family members (such as a spouse or children) are shareholders in the business.
Alternative minimum tax
As its name suggests, alternative minimum tax (AMT) is an alternate way to calculate taxes to ensure that high income earning individuals pay a minimum amount of tax when benefiting from certain deductions, including the LCGE. Taxpayers must pay the higher of AMT and “regular” taxes in a given year. Where AMT is the higher amount, the amount paid in excess of “regular” taxes can be used to reduce taxes in the seven subsequent years. By understanding the impact that AMT can have on the sale of a business, vendors can avoid surprises and ensure the necessary cash is available.
Capital gains reserve
In some transactions, the vendor may agree to receive the sale proceeds over a number of years. Where a sale is structured in this way, the vendor will have the option of deferring a portion of the capital gain realized on the sale by claiming the capital gains reserve. Generally, at least 20% of the capital gain must be reported in the year of sale and each of the four subsequent years.
Transferring the business to the next generation
An estate freeze refers to a transaction whereby the existing shareholder or shareholders of a company “freeze” the value of their ownership with any future growth of the company accruing to a new shareholder. This may be useful where the business succession plan is for the current owner’s child or children to take over the business. The next generation may not have the ability to purchase the company outright and it may not be the parents’ intention that they do so.
To implement an estate freeze, all existing common shares in the company would be exchanged for preferred shares with a cost equal to the current common shares and a redemption value equal to their current fair market value. A newly established family trust in which the child or children are beneficiaries would then subscribe for new common shares in the company. Alternatives may include:
- The child or children holding the new common shares directly; or
- The parent subscribing for a portion of the new common shares and continuing to benefit from some portion of the future growth in the company (referred to as a “partial estate freeze”).
Following an estate freeze, the preferred shares could be redeemed by the corporation over time to provide the parent with funds from the company on a regular basis. Such redemptions would result in deemed dividends. Where the parent does not require funds from the corporation, the preferred shares could simply remain outstanding and ultimately upon death, a deemed capital gain would be realized.
Capital gains reserve revisited
An alternative may be for the child or children to purchase the shares but with the sale proceeds being received over a period of time. As highlighted above, the parent may be able to utilize the capital gains reserve in this scenario. Where the shares sold by a parent to their child are QSBC shares, the capital gains reserve can be utilized over a maximum ten year period (as opposed to the regular five years).
Start tax planning early
As highlighted in our ATB Business Transition Guide, 72% of Canadian business owners intend to exit their businesses in the next decade. If this is your intention, we recommend that you consider tax planning in the context of your succession plan.
This document has been prepared by ATB Wealth. ATB Investment Management Inc., ATB Securities Inc. (Member Investment Industry Regulatory Organization of Canada and Canadian Investor Protection Fund) and ATB Insurance Advisors Inc. are wholly owned subsidiaries of ATB Financial and operate under the trade name ATB Wealth. The information provided in this article is a simplified general summary and is not intended to replace or serve as a substitute for professional advice. Professional tax advice should always be obtained when dealing with taxation issues as each individual’s situation is different. This information has been obtained from sources believed to be reliable but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. This information is subject to change and ATB Securities Inc. (Member Investment Industry Regulatory Organization of Canada and Canadian Investor Protection Fund), ATB Investment Management Inc. and ATB Insurance Advisors Inc. reserves the right to change the information without prior notice, and does not undertake to provide updated information should a change occur. ATB Financial, ATB Investment Management Inc., ATB Securities Inc. and ATB Insurance Advisors Inc. do not accept any liability whatsoever for any losses arising from the use of this document or its contents.