Selling your business to a family member will generate significant income, which will be taxed. Depending on how you arrange the transaction, the tax authorities will treat that income as either a capital gain or a dividend. You want them to consider it a capital gain!
- Maximum tax rate of 26.6%
- In 2023, the first $971,190 is eligible for the capital gains deduction
- Maximum tax rate of 48.7%
- no capital gains deduction because it’s dividend income
The $971,190 capital gains deduction is a lifetime maximum. For example, if you have previously used a $50,000 deduction, you will only be entitled to $921,190. The deduction is indexed every year and could increase in 2024.
Capital gain or dividend: How they’re different
Twenty years ago, Robert founded his company with a $10,000 investment. Now he wants to sell it to his daughter Mélanie for $2 million.
She will pay him over time, from the profits. Robert must include this amount in his income tax return.
If the tax authorities consider the income to be a capital gain:
- Income: $2,000,000
- Invested capital: $10,000
- Capital gain: $1,990,000 ($2,000,000 minus $10,000)
- Capital gains deduction: $971,190
- Capital gain on which Robert will pay tax: $1,018,810 ($1,990,000 minus $971,190)
- Maximum tax rate: 26.6%
- Tax payable at the highest rate: $271,003
- Robert may also have to pay the alternative minimum tax, which could be payable over a maximum of 7 years.
If the tax authorities consider the proceeds of the sale to be a dividend:
- Income: $1,990,000
- Maximum tax rate: 48.7%
- Tax payable at the highest rate: $969,130
The difference: $698,127
Of course, this is just an example, and each case is different. “But capital gains is always the best strategy,” says Patrick Giroux, Senior Tax Advisor at Desjardins. And it’s all thanks to the changes announced in Bill C-208, which was passed in 2021.
All thanks to Bill C-208!
Prior to June 29, 2021, Robert would not have been able to take advantage of capital gains (at least not for his federal taxes). The reason? Because the buyer was a family member, the tax authorities would have treated his income as a dividend. In other words, to benefit from the capital gains deduction (and as a result, pay much less tax) Robert would have had to sell his shares to an external buyer!
The new Bill C-208 corrects this inconsistency. It allows the family to structure the transaction according to their needs.
How to structure the transaction:
In the example above, Mélanie doesn’t have $2 million in cash assets. She will pay her father with the profits from the business or through a business loan.
- She will then create a holding company that will own the operating company (the “real” company).
- Robert will sell his shares in the operating company to the holding company.
- The holding company will borrow funds to pay for Robert’s shares.
For Mélanie, this set-up is very beneficial. The holding company pays Robert directly, without going through Mélanie. This way, Mélanie pays no personal tax on that money. Otherwise, she would have to withdraw $4 million from the business (for example, in the form of salaries or dividends), pay $2 million in taxes, and then pay the remaining $2 million to Robert.
For Robert as well, this is a winning approach. The sale of the shares will not be considered a dividend, but a capital gain, with all the relevant tax benefits.
The transaction will have to meet certain conditions, however.
What conditions must be met?
“It only applies to the transfer of shares,” Giroux points out. “Not company assets!”
It’s also only for transactions between direct descendants, for example between Robert and his daughter, or between Robert and his grandchildren (or his wife’s children and grandchildren). If Robert sold his business to his brother, his income would be considered a dividend.
These are the main conditions to be met. Is your business a family farm or fishing corporation? Some conditions are different.
For the transferred business (if not a family farm or fishing corporation):
- It must be incorporated, therefore, it must have shares. This strategy doesn’t work for partnerships (which have no shares, only units) or registered companies (which have no shares or units).
- It must be private. Companies listed on the stock exchange are excluded.
- It must be an operating company.
- 24 months prior to the transaction, at least 50% of the assets must be used primarily for operations.
- At the time of the transaction, at least 90% of the assets must be used primarily for operations.
- To take full advantage of the capital gains deduction, the company’s capital must not exceed $10 million.
- Between $10 and $15 million, the deduction is gradually reduced.
- Above $15 million, there is no deduction.
For the seller (in our example, Robert):
- The seller must have owned the shares for at least 24 months.
- They will pay tax on the fair market value of the business. In our example, the business is worth $2 million. Tax authorities will then consider the transaction amount to be $2 million, even though Robert was selling it to his daughter for much less.
- The seller can transfer all or part of their business.
For the buyer’s shareholder (in our example, Mélanie):
- They must be 18 or older.
- There may be more than 1 person who is a shareholder of the purchasing company (control must be held by the seller’s children or grandchildren).
- The purchasing company must retain the shares acquired for at least 60 months.
Additional criteria for Quebec!
Not only must your transaction meet the conditions set by Ottawa, but also those for your province. At the time of writing, Quebec imposes stricter criteria than Canada. Another good reason to consult with a tax specialist!
- The seller (in our example, Robert) must be an individual. Trusts are therefore excluded.
- The seller must have actually worked in the business during the 24 months preceding the transaction. However, they must stop after the transaction, unless their role is to facilitate the transfer.
- After the transaction, even if the seller continues to work in the business to facilitate the transfer, they must not receive a salary higher than the maximum allowable earnings under the Quebec Pension Plan.
- The seller must not retain legal control of the business after the transaction.
- After the first series of transactions, the seller must not retain more than 60% of the value of the business. After 10 years, they must not retain more than 30%.
What if the conditions are not met?
Tax authorities can be strict. If any of the conditions are not met, the business transfer will be deemed a transaction between related persons. As a result, the proceeds will be considered a dividend, and the seller will be more heavily taxed.
More flexible rules for a farm or fishing business
If your business is a family farm or fishing corporation, the rules are a little less strict. The main differences are:
- The deduction can be as much as $1 million, rather than $971,190 for other businesses.
- The capital gains deduction can be applied to interest in a partnership.
- If the business is personal (registered, 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, not the actual value of the business.
- In Quebec, the seller must not retain more than 80% of the value of the business following the first series of transactions, and no more than 50% after 10 years.
Planning is key to success
Transferring a business is a complex transaction. For example, 2 years prior to the transaction, the business may have to dispose of some of its assets to meet the requirement that 50% of assets are used primarily for operations.
As another example, the capital gain may impact alternative minimum tax or government assistance programs, such as the Old Age Security Pension. Your tax specialist will help you decide on the best time to complete the transaction and limit the impact.
“Plan ahead!” says Giroux. More specifically, plan ahead with your accountant, tax specialist and financial institution. You need the right players on your team. Too much money is at stake!