As the boomer generation of small-business owners moves closer to retirement, you should be on the lookout for clients who are starting to think about how they will exit their businesses.
There are a number of ways to do so that take advantage of tax rules specifically designed to encourage small, active Canadian businesses. But many business-owner clients are completely focused on the demands of running their business, and give little thought to how and when they will pass it on — until the moment arrives. As a result, advisors who can lend a hand at this critical stage may also find themselves tapped for a range of other services, such as estate planning, insurance and management of the resulting retirement nest egg.
Many small-business owners are now in their 50s and 60s and will be looking to retire in five to 10 years. They will want to know how to maximize the return from the sale of their businesses and minimize the taxes involved.
So, before your client hangs the “Closed” sign for the last time, it’s a good idea to put the options on the table. “The taxes on the sale of the business could be one of the biggest expenses that the business owner is going to pay in their lifetime,” says Prashant Patel, vice president, high net-worth planning services, in the wealth-management services division of Royal Bank of Canada in Toronto.
Fortunately, there are a number of tax strategies available to preserve business value, depending on the size of the business and the owner’s future plans. In most cases, these clients must decide if they want to sell shares or sell assets.
When it is shares that are being sold, the owner will be exposed to capital gains taxes. However, the owner can take advantage of one of the biggest breaks for small-business owners who are cashing out by using the $750,000 lifetime capital gains tax exemption for Canadian small businesses. This exemption can be significant, depending on the size of the business. For example, if your client makes $1 million in profit on the sale and the business qualifies for the exemption, the client is taxed on only the remaining $250,000.
To qualify, says Patel, clients and their tax advisors must “purify the business” to become eligible for the exemption under the requirements of the Income Tax Act. The business must be a Canadian-controlled, small-business corporation with 90% of its assets actively used in the business in Canada. The shares must be held by the taxpayer or his or her spouse for 24 months prior to the sale. In that period, at least 50% of the company’s assets must have been used in an active business — in other words, the exemption is not available to passive investments.
“It’s important to sit down [annually] with an accountant,” Patel says, “to ensure that the business qualifies for this capital gains exemption.”
A common cause of disqualification from the exemption, according to Jason Safar, partner in the tax services practice of Toronto-based PricewaterhouseCoopers LLP in Mississauga, Ont., is keeping too much passive cash in the business. Sometimes, business owners will keep extra cash in their business to avoid incurring additional taxes for the year. Instead, the owner and the tax advisor should structure the business to allow the strategic removal of this cash from the company. This tactic ensures the business falls within certain thresholds for size and business activities.
Another route is to multiply the effect by granting shares to family members. When family members, such as a spouse, children or grandchildren, are granted shares in a company, each person may be eligible for the $750,000 capital gains exemption. Typically, says Patel, in these cases, the shares are granted as part of an “estate freeze” transaction, in which the business owner exchanges common shares of the business for preferred or “freeze” shares; new shares then are given to the family members. Essentially, the current value of the business is frozen in the hands of the owner/founder, and future growth accrues in the hands of the new shareholders.
The business will still need to meet certain qualifications to take advantage of a multiple capital gains tax exemption. In order to qualify, family members must hold the shares two years prior to the sale, either directly or in a trust, says Patel. In addition, the business will have to continue to grow after the shares are granted. The family member’s exemption will apply only to capital gains related to the future growth of the company following that family member’s acquisition of the shares.
Sometimes, business owners view the small-business capital gains exemption as the Holy Grail of tax strategies, says Patel. But other strategies may be more useful.
For instance, if the business is worth $10 million and the owner is eligible for only one capital gains tax exemption, says Safar, then it makes more sense to focus on strategies that will reduce the taxes on the remaining $9 million of the sale.
One alternative is to do an asset sale. This route is becoming more popular with many business owners because of declining corporate tax rates, says Patel. As well, purchasers are keen to buy individual assets of a business because they don’t need to assume total liability for the company. Buyers also can select the assets that are best suited to their own plans.
In some cases, it may be best to do a hybrid transaction that involves the sale of both the shares and the assets, says Safar. But that strategy depends on the size of the company and how intricate the business owner wishes to make his or her affairs.
Not every client wants to retire immediately after selling the business. Those looking for a new venture can defer paying capital gains taxes on the value of their small business by investing the proceeds of the sale into a second, new company, says Patel. The money must be invested in the new company during the year of the sale or 120 days after yearend to qualify for the deferral. Your client would pay the taxes on the first business upon the sale of the second.
If your client is ready for retirement, he or she can still defer paying taxes through a “safe income strip,” says Patel. By placing profits from the sale in a holding company, he says, the seller will pay taxes only as he or she takes money from the holding company’s account over time. IE