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Small business capital gains exemption

I am constantly surprised that many small business owners I talk to are virtually unaware of the tax benefits when they are thinking of a succession plan or of selling the shares of their company.


May 28, 2009
By Mark Borkowski

I am constantly surprised that many small business owners I talk to are virtually unaware of the tax benefits when they are thinking of a succession plan or of selling the shares of their company.

In the 2007 federal budget, the lifetime capital gains exemption was hiked 50 per cent to $750,000, which means that the first $750,000 of the sale price of each shareholder’s company “shares” will have a capital gain that is exempt from all income taxes. Under Canadian tax laws, taxpayers bring only 50 per cent of the remaining gain into play as income and pay taxes only at their individual marginal tax rate. And, there’s some intriguing ways to further maximize the net gains in situations when a couple wants to pass on their business to their children. So, how does this work?

Well, under the “freeze,” the parents exchange their common shares in the enterprise for preferred shares frozen at the current value of their business. Let’s say it is $4 million. This means that the business’s future growth will flow to newly created common shares held in the trust that names the children as beneficiaries, and therefore from this point, only the children will benefit from future growth and capital gain.

Then, sometime in the future when the parents finally decide to sell for $7 million, the family trust would designate the capital gain to the children as named beneficiaries. So, if there were three offspring, each would receive $1 million. When each child claims their capital gains exemption of $750,000, they would therefore be liable to pay taxes on only $250,000 each. And the marginal tax rate for each child would, of course, depend on that child’s individual situation. In effect, this creates five different capital gains exemptions instead of the original two and that acts to considerably lower the tax liability for all concerned.

Often, when a small or medium-sized business owner sells, part or most of the purchase price is paid out over an extended period of time. This offers an opportunity to spread or defer the capital gains over several years. So, if the balance of the purchase price is doled out in periodic payments, it is highly recommended that a maximum 20 per cent be paid each year for a period of five years.

It should be noted that if someone has already cashed in some of the entire previous capital gains exemption limit of $500,000, the $750,000 new limit would, of course, be accordingly reduced. Would you be surprised to learn that Canadian tax laws also offer restrictions that define how people can qualify for these exemptions? There are three basic tests.

One, taxpayers must have owned the enterprise more than 24 months before the sale. This is known as the “holding period.” Two, during this holding period, the business must have used more than half of the enterprise’s assets at current fair market value. Three, on the actual date of sale, the enterprise must have been employing more than 90 per cent of these assets.

There can be other complications. If a Canadian company has an asset in the form of an American subsidiary, the U.S. asset would not be allowed to be included in calculating the capital gains and therefore the exemption totals. So, the highly recommended course of action would be to separate the two assets to be two separate entities.

How much can a seller of a small business enterprise save? It all depends on where a seller resides and their own individual marginal tax rate. But, the exemption can convert into significant savings.

Mark Borkowski is president of Mercantile Mergers & Acquisitions Corp. Mercantile specializes in the sale of privately owned mid market companies. E-mail: mark@mercantilema.com