In our recent blog, Do I Need a Holding Company?, we stated that a common goal of a holding company is to take advantage of the Lifetime Capital Gains Exemption (LCGE). Regardless of a business owner’s intention to either sell their company to a third party or transition it to the next generation, a good deal of planning must take place to make the most of the exemption.
The LCGE helps business owners and their families by allowing them to avoid paying taxes on capital gains (up to a certain amount) when they sell shares in a qualified business, farm property, or fishing property.
A qualified small business corporation refers to a Canadian Controlled Private Corporation where:
- More than 50% of the fair market value of the assets of the corporation were used mainly in an active business carried out primarily in Canada, or by a related corporation
- You have owned the shares for the preceding 24 months prior to selling them
- At the time of the sale, 90% or more of the value of the business's assets were used for carrying on an active business in Canada
Good planning can help you and your family members, who own shares in your private company, ensure the shares are eligible for the capital gains exemption.
If your business fails to meet the above QSBC criteria, there may be purification strategies you can implement. One of the commonly used purification strategies is to reduce the passive assets in the business by transferring these assets to a holding company (holdco). The owner would transfer passive assets from the operating company (opco) to the holdco, and then sell their shares of the opco once they pass the exemption tests.
If you disposed of qualified small business corporation shares (QSBC shares), you may be eligible for the $883,384 LCGE in 2020. Because only half of the capital gains from these assets are included in your taxable income, your cumulative income deduction would be $441,692.
For dispositions of qualified farm or fishing property (QFFP) in 2020, the LCGE is $1,000,000. Because only half of the capital gains from these properties are included as taxable income, your cumulative income deduction would be $500,000. QFFP property comes with its own unique set of requirements that may be best addressed by a specialized accounting and legal team.
It is important to note that the LCGE is only for individuals and cannot be claimed by corporations or holding companies.
Furthermore, this exemption is a lifetime cumulative exemption. This means that you do not have to claim the entire amount at once. For example, if you sold shares of a small company, say, two years ago and claimed $300,000 of exemption, you still have approximately $583,000 available to claim in future.
Business succession is planning for the disposition of the business assets, often in the most tax effective way. Completing an estate freeze, given the current environment, may be advantageous since many business valuations have recently dropped due to COVID-19. An estate freeze is a way to ‘lock in’ the value of a company and accrue new growth to the next generation of owners.
LCGE can be a powerful tool in business succession planning by executing an estate freeze, which is also referred to as crystallizing the LCGE. Crystallization is an approach where an individual triggers a capital gain at a time when the shares qualify for the exemption without actually disposing of the shares. The crystallization transaction can occur during the shareholder’s lifetime or upon their passing, increasing the cost basis of the shares transferred to the deceased individual’s beneficiaries.
Another tax efficient strategy to pursue may be the creation of a family trust. Trusts are often used in succession planning, and can result in a multiplication of the capital gains exemption for a family-run business.
The use of a trust within the framework of a private corporation has a number of benefits. When an individual passes away in Canada, they are deemed to have disposed of their assets at fair market value (FMV) for tax purposes, except for a spousal rollover. If the FMV of the business assets exceeds their cost base, the “deemed disposition” results in capital gains on which the estate must pay tax. Assets transferred into and held by a trust are not subject to this deemed disposition, and this can considerably reduce an estate’s final tax liability.
Capital property, which would generally include the shares of a private corporation, may be distributed to a trust’s Canadian-resident beneficiaries at cost (i.e., on a tax-deferred basis).
The trust can sell the shares of an opco and assign the resulting capital gain to multiple beneficiaries of the trust, including adult children. The business owner’s spouse and adult children can then each claim their unused LCGE of $883,384 to reduce or eliminate the capital gains of a QSBC. However, it is important to keep the Tax on Split Income (TOSI) guidelines in mind. It may be the case that the TOSI rules apply to one family member but not another, to one type of business and not another, or in one year but not another. The new rules will require business owners to review their current business arrangements to minimize the impact of the TOSI rules, and determine the best manner of distributing business profits in the future.
We recommend that clients seek professional tax advice before diving into some of these complex strategies. At CWB Wealth Management, we provide integrated wealth solutions for our private wealth clients. Our client teams have strong relationships with accountants and lawyers that can help assess these strategies for you. Please fill out the form below to have one of our private wealth team members reach out to you.
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