Family successions: How to minimize the tax hit
Taxes are one of the main considerations when it comes to a family succession. Without proper planning, you can wind up with a larger-than-expected tax bill in a family succession and have no way to pay it.
It’s important to get started early on to structure the transaction in a way that minimizes your tax liability. It can take several years to implement the optimal structure.
“Planning can help you significantly reduce your tax liability in a succession,” says Bruce Ball, a Chartered Professional Accountant and member of the tax policy committee at CPA Canada. “Failing to do so could mean the business has to close or be sold. Or perhaps it might have to incur an unhealthy level of debt.”
Here are steps Ball suggests you consider. (Note: You should get professional tax advice about your specific situation. Also, rules differ for fishing and farming businesses.)
1) Start early—Consult a tax expert early on about the tax consequences of a succession. Many entrepreneurs wait too long and the transition ends up happening in a crisis—for example, due to a health issue or death. That can lead to lost opportunities to save on taxes.
“The worst case scenario is that the business passes to a child on death, but the family doesn’t have the means to pay the tax on the accrued capital gain,” says Ball, who is also national tax partner at BDO Canada.
2) Minimize capital gains tax—Whether you pass on your business in a sale or give it as a gift to a family member, it’s deemed to be disposed of at its fair market value. You are taxed on half the gain in the company’s value (as a capital gain) at your top tax rate. The capital gain is calculated on the difference between the business’s initial share cost and today’s share value.
(There is an exemption for a transfer to a spouse, in which case the gain and tax are deferred until the spouse sells or gifts the business.)
If the business is a qualified small business corporation, you can claim a lifetime capital gains exemption to reduce this tax. The exemption is $824,176 in 2016, meaning a gross gain of up to this amount is tax-free. The exemption is indexed to inflation and, hence, increases each year.
To qualify for the exemption, a company must meet several conditions. For example, it must have been owned by the same person for the past 24 months, and at least 90% of its assets must be used for business primarily in Canada at the time of transfer. See a detailed list of the conditions here and more information on the capital gains exemption here.
3) Consider an estate freeze—An estate freeze is a way to essentially lock in the gain (and capital gains tax) based on the company’s value. A common way of doing so is by exchanging your common shares in the company for fixed-value preferred shares, and then issuing common shares to your children. Any future growth in the company’s value goes to the common shares and isn’t taxed until your children in turn sell or gift their shares. The shares can be held by the children directly or in a trust.
4) Think about incorporating—If you haven’t already incorporated your business, think about doing so. Owners of an unincorporated business don’t qualify for the lifetime capital gains exemption and generally can’t do an estate freeze.
5) Defer taxes—You may be able to defer some of the capital gains tax if you help finance the sale and are being paid over several years. In this case, you may be able to declare the capital gain over the duration of the payments, for up to 5 or 10 years depending on the circumstances.