Financial advisors with clients who are selling small businesses are in the unique position of being able to quarterback the sale. Part of that will mean being well versed in tax treatment fundamentals.

“[Advisors] don’t have to know all of the fine points, but they can be at the centre of advice for referrals for their clients,” says Jamie Golombek, vice president of taxation and estate planning at AIM Funds Management Inc. in Toronto.

For tax purposes, planning for the sale of a business should begin at the company’s inception, says Golombek: “The important point is the need for professional tax or legal advice from the very beginning. It’s hard to do retroactive tax planning. There are some things you can do at the very end, but you should know your exit strategy from the very beginning. And from there, you can set up holding companies or trusts.”

The greatest potential tax savings on the sale of a business are available when the owner incorporates the business and designates him- or herself, other business partners and family members, if possible, as shareholders. If Canada Revenue Agency recognizes the company as a qualifying Canadian-controlled small business, each shareholder’s disposition is subject to a capital gains exemption on the first $500,000 when the business is sold.

The CRA’s capital gains exemption for the small-business designation comes with many caveats, and often business owners need to undergo what is known as a “purification” process to qualify.

For example, let’s assume the business was worth $100,000 when it was established and it was sold for $600,000. “I’ve set up my company and everything was done perfectly. My taxable income is zero, but I still have $500,000 cash, tax-free, on the disposition of the company,” says Bruce Cumming, a registered financial planner with Cumming and Cumming Wealth Management, a FundEx Investments Inc. operation in Oakville, Ont.

Timing and planning are critical because the corporation needs to have filed taxes during two previous business years to make it eligible for the exemption.

For business owners who choose not to incorporate, or for those who decide to do so
too late, there are plenty of cautionary tales in the classified sections and ads of newspapers that feature liquidation sales at 60¢ on the dollar, says Peter Wouters, director of tax and estate planning at Empire Financial Group, which is based in Kingston, Ont.

The bane of the selling business owner is the desperate, straight-up asset sale, in which the seller absorbs the cash from the purchase as a one-time capital gain.

Asset sales

In this situation, a business seller and buyer can be at cross-purposes. The buyer may not be interested in the goodwill inherent in the name of an established business or in a niche client base that comes with the sale, and is more interested in the assets alone.
And the asset sale comes with no liabilities, in the form of either debt or future lawsuits. It’s much simpler.

“Also, as a buyer of assets, you effectively buy a higher capital cost allowance,” says Wouters, whose office is in Burlington, Ont. “An asset purchase is an opportunity to re-evaluate the capital, and start the depreciation all over again.”

Wouters suggests timing the sale for just after the end of a tax year can be helpful for the seller, who can consider how much of the money he will need and how he’ll manage the sale from a tax perspective over the next 12 to 18 months.

With careful planning, a seller can multiply that one-time $500,000 tax exemption. Assuming the sale of the business generates $2 million in capital gains, equal parts of ownership can be assigned to his or her spouse and children, assuming two of the latter.
Each of the owners could take advantage of $500,000 in exemptions and, between the four family members, no taxes would be incurred upon disposition.

A different arrangement can be made if the business owner has no spouse or children. Beyond the $500,000 tax exemption, the rest of the cash from that sale is absorbed as capital gains, but the Income Tax Act allows the seller to pay taxes on the capital gains over a five-year period instead of incurring a single, large tax burden.

@page_break@If a buyer cannot finance the entire purchase of a business, this tax treatment works well. Still assuming the business is valued at $2 million, the seller can take the $500,000 capital gains exemption on the buyer’s down payment, and slowly absorb the taxes incurred on the $1.5 million in capital gains.

“I’ve used up my exemption. But over the next five years, I can use this capital gains reserve, so that I don’t have to pay all of the taxes up front,” says Cumming.

Of course, there can be unique hurdles. For example, passive income — or the cash reserve owned by the business before it is sold — can create both problems and tax-efficient opportunities with regard to the sale of a business.

Assume a business has accumulated a cash reserve of $200,000 over its years in operation. As part of the “purification” process, this passive income must be removed from the company for a minimum of two years before its sale in order for shareholders to have access to the $500,000 capital gains exemption. It is the single most common reason the CRA will disqualify a small-business shareholder from accessing the exemption, Cumming says.

Creating an individual pension plan, or IPP, before the sale of the business solves the problem. To do this, the shareholders create a pension plan that becomes a large tax-deductible expense for the company. Depending on the shareholders’ ages, salaries and previous RRSP contributions, an actuary can calculate how much of the passive cash can be transferred into the pension plan, which becomes a blend of the existing RRSP contributions and the new corporate cash, and it can be multiplied many times over for each shareholder.

Cumming says many owner/ managers haven’t availed themselves of the IPP. “The point is the option is still there if you do it two years before you sell the company.”

Cumming says it’s important to scour the Income Tax Act for sections that may apply to businesses in operation before 1995, when substantial parts of the code changed.
Assume the business owner runs an incorporated business from 1980 until 2006. Before he or she sells the company, the owner formally retires. With its accumulated passive income, the company is still able to make a $2,000 RRSP payment per year or partial year from 1980 until 1995 (when the act was amended). That’s a $32,000 tax-deductible expense for the company.

“Plus, from 1980 to 1988, [the company allots the retired owner] an extra $1,500 a year, or $13,500, because the company did not have a registered pension plan,” says Cumming, referring to tax act provisions. “These are all techniques to take money out of the company prior to the sale in a tax-effective manner.” IE