Selling your business shares to a family member?

A new law means significant tax relief when you pass your business on to your kids.

A recent change to Canada’s Income Tax Act (ITA) could reduce the tax sting associated with selling your business shares to a family member.

Bill C-208 was given royal assent, becoming Canadian law and amending the ITA, in June 2021. Families looking to transfer shares of family farms, fishing corporations or small business corporations to their children and grandchildren are now in line for what could be significant tax relief.

What Bill C-208 changes

Before the passing of Bill C-208, the Income Tax Act dictated that when parents sold shares of a business to a family member’s corporation, like a child or grandchild’s holding company, the proceeds would be taxed as dividends rather than capital gains.

That provision created something double-standard, as sales of business shares to a non-family member’s corporation were considered capital gains, requiring only 50 percent of the proceeds to be taxed at the seller’s marginal tax rate.

Taxing those proceeds as dividends, which receive far more severe treatment from the Canada Revenue Agency, resulted in business owners taking an additional tax hit of over 20 percent.

A company or holding company acquiring shares was fine, but your child or your grandchild’s company acquiring the shares was not. The previous legislation was meant to prevent business owners from setting up new companies solely to buy shares in their old ones and avoid declaring the proceeds as dividends.

Now that sales of company shares to family members receive capital gains treatment, sellers may also be able to take advantage of the lifetime capital gains exemption (LCGE), which allows them to realize tax-free capital gains on proceeds totalling up to $892,218 for 2021 tax year if the asset being sold qualifies.

Let’s say you sell shares of your company to your brilliant, successful daughter’s holding company for $1 million. If you’ve never tapped into your LCGE, you could use the entire exemption to shield almost $900,000 of the proceeds from being taxed. Of the amount left, only 50 percent will be taxed as capital gains.

Things to keep in mind

Bill C-208 only extends to certain types of businesses: family farms, fishing corporations and “small business corporations,” which don’t necessarily need to be small. Still, they need to be private and Canadian to receive the new tax treatment. They also need to be active. A corporation that owns an investment portfolio or a collection of apartment buildings, for example, doesn’t qualify.

For purposes of a sale just getting capital gains treatment, you’d want to make sure that the corporation that is buying your shares is buying small business corporation shares, not publicly-traded entities, not U.S.-owned businesses.

There’s also a time threshold that needs to be considered. Launch a business today and sell it tomorrow, and the proceeds will be taxed as dividends. To receive more favourable tax treatment, you must own your business for at least two years. During those two years, you’ll have to prove that more than half of the assets you hope to sell have been used actively by your company.

To ensure the accuracy of those records – and any others your company keeps, it’s important to secure some form of professional monitoring in the two years leading up to the date of sale. A little outside help can also prevent the sale of your business from being derailed by any less-than-best practices you may have established while doing your books over the years.

Remember that part of the pre-sale planning will also need to include an objective, professional third-party valuation of your shares. Ballparking what they’re worth or trying to give your descendants a deal on your shares won’t cut it with the CRA.

Amendments could be on the way.

Even though the bill is now law, the Department of Finance announced in July that Bill C-208 could be subject to at least some government tinkering in the form of amendments that remove the kinds of loopholes some business owners may be tempted to use to reduce their tax bills further.

No significant changes are expected. The final version of the amendments has yet to be announced.

This article provides information only and should not be construed as advice. It is provided without a warranty of any kind.

Don’t hesitate to contact RGB Accounting by phone at (416) 932-1915 or by email at [email protected] if you have any questions. We’ll be pleased to assist you.

Source: Financial Post