5 ways companies can pay capital gains

When a business is sold, passed to the next generation, or otherwise transferred to other owners, all capital gains taxes are triggered and payable. That’s a potentially mammoth tax burden.

Approximately 23% of the fair market value of a company, assuming a cost base of zero, is payable in tax at the time the children acquire ownership. For example, a manufacturing business has a fair market value of $25 million. When the owner sells or passes ownership to his adult children, nearly $6 million goes straight to the CRA. That can often restrict business activities, especially if the transfer of ownership takes place suddenly (say, due to unexpected death of the owner or key person).

There are a number of strategies that can limit, defer or reduce this tax including capital gains exemption, estate freezes and spousal rollovers. I advise my business owner clients of five options when planning for the tax payment: cash, sinking fund, selling assets, borrowing money and insurance. Let’s look at them one by one.

Cash

Using cash to fund the tax can be quite expensive. These funds are after-tax dollars, so they have already been taxed at a significant rate. Funds inside an operating or holding company, must be transferred to the estate to pay the tax. And those funds can attract additional tax.

Cash is king and keeping at least some liquid funds helps a growing business, provides comfort in emergency planning and strengthens the balance sheet, which can attract future investment.

Allocating cash for tax payments effectively locks it up and any future growth and opportunities the cash could provide are lost forever.

Sinking Fund

A sinking fund is a viable option, however, there are two variables in play. Does the business owner have enough time to accumulate the necessary amount? Can guaranteed investments produce meaningful returns and liquidity?

Selling an Asset

This is probably the easiest solution, but it can paralyze a business. Typically the most attractive, most important assets of the corporation have to be sold first—often the building that houses the business. Sell the building and you may be selling the comfort of having control of your plant or office facility.

Timing, market conditions, and selling costs can add another layer of uncertainty in the asset sale approach.

Borrow From the Bank

Most lending institutions are not prepared to lend funds for purposes of paying tax (which clearly does not stay on the balance sheet).

If a key executive or shareholder dies, banks become increasingly protective of their positions, and watch succession plans and the new generation of owners more closely.

This is a costly option because the loan must be repaid and interest payments would not be deductible.

Insuring the Tax

Using insurance to pay tax is a cost- and tax-effective approach. A properly designed and implemented insured tax program can provide the funds tax free, at exactly the time required.

The policy can be personally or corporately owned while still providing the funds tax free to beneficiaries and/or shareholders of the company.

As with all life insurance policies, there will be medical underwriting. Even in situations where medical issues are a consideration it is still worth exploring the insured tax program.

Ted Warburton CLU, TEP is a principal at First York, an insurance planning firm in Toronto.