Are you planning on leaving your business to your children? It's a major milestone in a person's life. You wouldn't want to gloss over any of the legal or human aspects involved. And what about taxation? Sometimes, a small mistake can make a big difference come tax time. Here's how you can avoid some of the more common ones.
Selling your business to a family member can generate income or a capital gain, both of which are subject to tax. Depending on how you arrange the transaction, the tax authorities can classify the income associated with the transfer as a capital gain or as a dividend. You want them to treat it like a capital gain!
Capital gain:
- Maximum tax rate of 26.6%
- In 2026, the first $1,275,000 you earn from selling shares is eligible for the capital gains deduction. This limit is indexed to inflation annually.
Dividends:
- Maximum tax rate of 48.7%
- Dividend income is not eligible for the capital gains deduction.
The $1,275,000 capital gain deduction is a lifetime limit. For example, if you've already deducted $50,000 under this exemption, your remaining deduction limit would be $1,225,000.
Capital gain or dividend income: How they differ
Around 20 years ago, Robert used $10,000 to start a business. Today, he wants to transfer $2 million in shares to his daughter, Melanie, who will use the profits to pay him back over time. Robert will need to disclose the value of the transaction on his income tax return.
If the tax authorities treat this income as a capital gain:
- Income: $2,000,000
- Capital investment: $10,000
- Capital gain: $1,990,000 ($2 million minus $10,000)
- Capital gains deduction: $1,275,000 (assuming Robert hasn't claimed any prior capital gain deductions)
- Robert's taxable capital gain: $715,000 (or $1,990,000 minus $1,275,000).
- Maximum tax rate: 26.6%
- Taxes payable at the highest rate: $190,190.
- Robert may also have to pay an alternative minimum tax, which can be recovered over a maximum of 7 years.
If the tax authorities treat the proceeds from the sale as a dividend:
- Income: $1,990,000
- Maximum tax rate: 48.7%
- Taxes payable at the highest rate: $969,130
The difference: $778,940
This example is highly simplified. It’s important to remember that each case is unique. “Treating the income as a capital gain tends to be the best strategy,” says Patrick Giroux, Senior Tax Advisor at Desjardins. This is thanks to the changes that were announced in 2021 under Bill C-208, which was adopted the same year, the terms of which have been in effect since 2024. The good news is, Quebec has aligned its tax policies with these measures as well.
Prior to 2024, it would have been difficult for Robert to take advantage of capital gains. The reason being, since the buyer is a member of his family, the tax authorities would have had to treat the sale as dividend income. In order to benefit from the lower tax rate afforded through the capital gains deduction, Robert would have had to sell his shares to an external buyer.
The new provision fixes this discrepancy and gives the family a chance to organize the transaction in a way that aligns with everyone’s best interests.
How to set up the transaction?
In the example we just described, the $2 million in shares that get transferred to Melanie are not liquid. She will pay her father back with proceeds from the business or by taking out a business loan.
- She will create a management company that will officially own the operating business.
- Robert will sell his shares in the operating business to the management company.
- The management company can take out a loan to purchase Robert’s shares.
For Melanie, this financing package is a good deal. The transaction takes place between Robert and the management company, with zero involvement from Melanie—who will not have to pay any personal income tax in connection with the sale. Otherwise, she would have had to withdraw $4 million from the company (in wages or dividends), pay $2 million in taxes, and then pay the remaining $2 million to her father, Robert.
This arrangement is also beneficial for Robert. The shares he sells are not treated as dividend income, but as a capital gain, with all of the ensuing tax benefits.
The transaction must respect certain conditions, however.
“The arrangement only applies to the transfer of shares, not the company’s assets,” says Giroux.
What conditions must be met?
- The seller must be an individual.
- The shares that are sold must be eligible for the capital gains deduction.
- The acquiring company must be controlled by at least one of the seller's adult children. The term "child" has been expanded to include all direct descendants and some other family members, including nieces and nephews and the seller's spouse's children.
Quebec also relaxed the rules
Your transaction must not only meet the conditions set by Ottawa, but also those for your province. Until 2024, Quebec used different criteria than the federal government. However, as of 2024, they have fully aligned with the federal rules.
Additional conditions have been introduced to ensure that the intergenerational transfer of a business is genuine. Criteria have also been established regarding the transfer of decision-making authority, economic and management interests, the next generation’s involvement in the company and the retention of ownership.
What if conditions are not respected?
Tax authorities can be strict. If prescribed conditions are not met, a business transfer will be considered a transaction between related persons. The proceeds from the sale will be treated as dividend income, and the seller will be required to pay more tax.
Planning ahead is a key to success
More flexible rules for farm and fishing businesses
If your business is a family farm or fishing business, the rules are a little more flexible. The main differences are:
- The capital gains deduction can be applied to interest in a partnership.
- If the business is personal (registered or a partnership, not incorporated), assets such as land and quotas qualify for the deduction. However, inventories such as herds, feed, and machinery do not qualify.
- The seller will be taxed according to the transaction amount for the purpose of a transfer to a child, and not according to the actual value of the business.
Transferring a business is a complex transaction. For example, two years before the transaction, the business may have to dispose of certain property to meet the criteria stating that 50% of the company’s assets must be primarily dedicated to business operations. What’s more, a capital gain can impact your Alternative Minimum Tax and government assistance programs such as the Old Age Security pension. By working with a tax specialist, you can mitigate your tax impacts by choosing the right moment to pursue the transaction. Patrick Giroux advocates for planning ahead. Or, more specifically, he urges business owners to work with their accountant, tax expert and financial institution to make a plan. Having the right people on your team is everything. The stakes are high. Maximize your chances of doing it right!