Jeff Saunders, CPA, CA, Tax Partner, Teed Saunders Doyle & Co., Fredericton, NB, DFK Affiliate Firm
As the baby boomer generation reaches retirement age, we are seeing an increase in the number of small and medium sized businesses being sold. In selling a business, many business owners want to take advantage of the Capital Gains Deduction.
In basic terms, the Capital Gains Deduction allows an individual who owns shares in a “QSBC” (a Qualified Small Business Corporation), or a qualifying interest in a farm or fishing business to sell their shares and receive up to $813,600 in capital gains without paying tax. (Alternative Minimum Tax [AMT] may apply depending on the individual’s other income.) This large tax break is obviously very attractive to someone selling their business.
However, there are tax rules that apply only in the special circumstances where the purchaser and vendor are not dealing at arm’s length. Many sales of family businesses from one generation to the next generation will be considered to be non-arm’s length transactions. A mother selling shares of her QSBC to her daughter is just one example of a purchaser and vendor not dealing at arm’s length. These special tax rules are designed to prevent abuse, but they can also have significant negative tax consequences on legitimate sales to the next generation.
If we were to look at two identical transactions with the only difference being that one of the transactions is not at arm’s length, such as a mother selling to her daughter, we would get very different tax results:
∙ Let’s assume that Mrs. A and Ms. X are not related in any way, that Mrs. A owns all of the shares of Opco Ltd. (a QSBC), that Opco Ltd. has a fair market value of $800,000, and that the adjusted cost base and paid-up capital of Mrs. A’s shares is $100. Ms. X incorporates her own holding company, Holdco Inc., and Holdco Inc. borrows $800,000 from a bank to purchase all of the Opco Ltd. shares from Mrs. A. Mrs. A will have a capital gain of $799,900 and she can claim her Capital Gains Deduction to not pay any tax on the sale. Up to $40,500 of AMT may apply depending on Mrs. A’s other income.
∙ Now if we assume that Mrs. A and Ms. X are mother and daughter and all of the other facts in the preceding paragraph do not change, then the results are very different. The special rules in the Income Tax Act for nonarm’s length transactions will deem the $800,000 paid from Holdco Inc. to Mrs. A to be a dividend rather than proceeds on sale. So instead of receiving a tax-free capital gain of $799,900, she has now received a taxable dividend of $799,900. In Alberta, this taxable dividend would result in up to $235,000 in taxes.
These dramatically different results highlight one of the numerous tax issues that can arise in selling a business to the next generation. With proper advance planning and advice from your tax advisor, negative consequences like those illustrated above can be minimized or avoided.
In selling a business, many business owners want to take advantage of the Capital Gains Deduction.