Most small business owners that I talk to are aware of the capital gains exemption for Small Business Corporations, but very few know the details of how it works and fewer still are actively planning to take advantage of it. When entrepreneurs are just starting out, the concept of selling their newly minted business for large profits seems remote, and by the time the business is established, they are too involved in the daily operations to plan for its eventual disposition.
The amount of the capital gains exemption is indexed to inflation and for 2018 is currently pegged at $848,252 – you definitely do not want to miss out if your business qualifies!
Does my business qualify?
There are three tests that your business needs to meet in order to qualify for the exemption:
- At the time of the disposition, at least 90% of the company’s assets must be used in an active business carried on primarily in Canada.
- Throughout the 24 months prior to the disposition, more that 50% of the company’s assets must have been used in an active business carried on primarily in Canada.
- The corporation must be a Canadian controlled private corporation, and the shares must have been owned by the current shareholder or a related person for at least 24 months prior to the disposition.
What if my business does not meet these tests?
Fortunately, there are strategies that can be implemented to “purify” a company so that it meets the tests. The most common issue profitable companies have is that they have started to accumulate cash or investments within the corporation. When these funds are in excess of what is required to run the business, they do not meet the test of being assets “used in an active business”. There are several strategies that can be used to deal with this, such as using funds to pay down debt, or by declaring dividends to pay out excess cash. If a holding company is not already in place, it may be advisable to create one in order to defer taxes on the dividends being paid out.
When should I start implementing these strategies?
At a minimum, you should start implementing strategies to ensure your company qualifies at least two years before any contemplated sale (so that the second test can be met). That being said, the question I always like to ask my clients (not to be macabre) is what if you walk out of my office and get run over by a bus? Upon death, you are deemed to dispose of your assets at fair market value (other than inter-spousal transfers) so by not dealing with the issue now, you are potentially turning an $800,000 tax free capital gain into a large tax liability for your estate.
The better answer is to ensure that your business is properly structured so that you are never accumulating excess funds within an operating company. This is also a good strategy for creditor protection so there is no excuse not to do it. You can set up the appropriate structures either right at the outset when you incorporate, or with a little additional effort, later on once the business actually starts generating those excess funds.
Common pitfalls
There are many pitfalls to watch out for including:
- Alternative minimum tax might turn what is expected to be a tax-free transaction into an expensive tax bill – especially when other sources of income for the year are low.
- There are various income-based tests that are calculated on total income before the capital gains deduction. This includes for example the claw-back of Old Age Security pension
- If you have claimed investment expenses in prior years that exceed your reported investment income, your capital gains exemption may be restricted.
You should seek out professional advice prior to engaging in a business transaction that might involve claiming the capital gains exemption.