Selling small business shares

Almost every succession plan for business owners involves the disposition of corporate shares. It might happen as part of an estate freeze, other reorganization or an outright sale to the next generation.

Although share dispositions, including sales and transfers, often result in the realization of capital gains, there are opportunities clients should certainly take advantage of to shelter or defer the tax on those gains.

The first opportunity is the capital gains exemption (CGE). With this exemption, up to $750,000 of capital gains realized by a Canadian individual on the disposition of qualified small business corporation (QSBC) shares can be completely tax free. To be eligible, they must fulfill the following conditions: they must be Canadian controlled private corporation (CCPC) shares, and at the time of disposition, more than 90% of the corporate assets (based on fair value) must be used in an active business carried on primarily in Canada.

In addition, the CCPC shares must generally have been owned by the individual or a related person throughout the 24-month period preceding the sale. In that time, more than 50% of the corporate assets (based on fair value) must have been used in an active business carried on primarily in Canada (the rules become complex when there are controlled or connected corporations). This means that newly issued shares generally must be held for at least 24 months.

There are exceptions, however, for shares acquired in exchange for other qualifying shares, through a previous reorganization or freeze, for example, and shares issued in exchange for the transfer of an unincorporated active business to a corporation.

It’s not unusual for an active business to accumulate non-active assets over time (such as portfolio investments purchased with excess cash). If these assets represent more than 10% of the total business assets, the shares won’t qualify as QSBC shares. In these cases, it may be necessary to purify the corporation and divest the company of its non-qualifying assets before the disposition to access the CGE.

There are a variety of ways to purify a company. The simplest is to pay out the excess cash or investments in dividends. This method is cost effective if there is refundable tax in the company, in which case the dividend refund effectively offsets the tax payable to the shareholder receiving the dividend. Or, where there is a capital dividend account balance representing the non-taxable portion of capital gains realized in the corporation, it can be paid out to shareholders tax free. If the company has significant liabilities, including amounts due to shareholders, these can be paid with excess cash and the liabilities can be reinstated once the capital gains exemption has been used. More complex purification transactions may be necessary if these simple methods aren’t sufficient.

Even if the QSBC test is met, there are other factors that may limit the CGE claim. If the individual has a cumulative net investment loss balance, the ability to claim the deduction is restricted. Also, an allowable business investment loss (ABIL) realized in the current year, and any claims made in the year for net capital losses of other years, reduce the net taxable capital gains eligible for the exemption.

Finally, keep in mind this is a lifetime exemption. If any amount has been used in the past, or if your client claimed the $100,000 general capital gains exemption before 1995, the maximum $750,000 exemption will be reduced accordingly.

In addition to the CGE, there are opportunities for tax deferral in certain cases. If company shares are sold in exchange for debt, a capital gains reserve may be claimed in relation to sale proceeds not payable until after the end of the year in which the disposition takes place. The reserve may be claimed for up to five years, with a minimum cumulative income inclusion of 20% per year.

A more generous reserve is available to the person’s children or grandchildren for gains realized on the disposition of small business corporation shares. In these cases, the reserve may be claimed over 10 years with a minimum income inclusion of 10% annually on a cumulative basis.

Gena Katz, FCA, CFP, an executive director with Ernst & Young’s National Tax Practice in Toronto. Her column appears monthly in Advisor’s Edge