Your clients have worked hard to build their businesses, and now it’s time to consider next steps.
Business succession planning is a key component to ensuring that their legacy continues into the next generation. Both transferring ownership to successors and selling a business involve tax implications to consider. Florence Marino, Head of Individual Insurance, Tax, Retirement and Estate Planning Services, provides a rundown of the various tax scenarios a business owner may face.
Sale of personally held shares to an outside party
The sale of the shares of an incorporated business will result in a capital gain or loss. The amount by which the sale price exceeds the adjusted cost base of the shares is a capital gain. One-half of the capital gain is taxable to the business owner. If the shares are “qualified small business corporation shares” and the shares are held personally, the business owner may be able to use his or her lifetime capital gains exemption to offset all or part of the capital gain. Following a share sale, the business owner would hold the after-tax proceeds personally to invest, fund his or her retirement and/or pass on to heirs at death.
Sale of corporate assets or corporately held shares to an outside party
Income from the sale of assets of the business or shares held by a holding company will be taxed inside the corporation. How the income is taxed depends on the type of assets sold and the income generated. The sale of depreciable assets, such as equipment, results in recaptured depreciation if the sale proceeds exceed the undepreciated capital cost. Recaptured depreciation is included in taxable income and taxed as active business income. The sale of non-depreciable assets, such as land or shares of an operating company, results in a capital gain equal to the sale proceeds less the adjusted cost base of the asset. One-half of capital gains are included in the taxable investment income of the corporation. Gains on the sale of intangibles and goodwill are also included in taxable income at a 50 per cent inclusion rate and taxed as investment income in the corporation.
Once the assets are sold and the taxes are paid by the corporation, the business owner will be left with a corporation holding the after-tax proceeds. The corporation can be wound up and the proceeds distributed to the business owner, or the corporation can remain, with the after-tax proceeds invested in the corporation.
If the business owner decides to wind up the corporation after the sale of assets, the cash and/or investments will be distributed, resulting in additional personal income taxes. Paid-up capital, shareholder loans and capital dividends can be distributed from the corporation tax-free and are generally distributed first. The remaining capital in the corporation is generally distributed as taxable dividends. The corporation would then be dissolved. The net after-tax amount would be available to the business owner to invest, fund retirement and/or pass on to heirs on death.
If the business owner does not wind up the corporation after sale, the personal tax can be deferred until the assets are distributed, which may not be until after death. Another option is to wind up the corporation gradually, distributing the funds over a number of years, which may take advantage of personal graduated tax rates and decrease the total taxes payable compared to a one-time wind-up.
If the business owner maintains the corporation, the after-tax proceeds from the asset sale can be invested inside the corporation. A high rate of tax is imposed on investment income earned in a Canadiancontrolled private corporation (approximately 51 per cent, depending on the province), but a portion of the tax imposed is refundable. The corporation receives a refund for a portion of the corporate tax paid when the corporation pays taxable dividends to individual shareholders. The shareholder may take dividends in retirement. Before distributing income to the shareholder, the cost of distributing the income versus retaining the income in the corporation should be considered if the shareholder has alternative sources of income available.
If the shareholder continues to hold shares of the corporation until death, there would be a deemed disposition of the shares at their fair market value immediately preceding death, resulting in a capital gain or loss. Post-mortem planning for shareholders holding investment company shares at death would be necessary to avoid the potential for double taxation: tax on the deemed disposition of the shares and tax on the winding up of the corporation.
Transfer to successors
A gift or sale of shares to a successor may occur during life or at death. This would result in a capital gain to the business owner at the time of disposition.
A common approach to business succession within a family is to do an “estate freeze.” An estate freeze allows a business owner to lock in the current value of his or her shares and thus “freeze” the tax liability arising from the growth in value of the company at the time of the freeze. It also allows a successor to come into the business with minimal capital contribution and participate in the future growth of the business.
An estate freeze can occur on a tax-deferred basis. The business owner exchanges his or her common shares in the operating company for fixedvalue preference shares either in the same operating company or in a holding company that owns the operating company. Assuming that all the common shares are exchanged and no other shares are outstanding, the preference shares will have a value equal to the value of the corporation at the time of the freeze. The business owner may choose to crystallize his or her unused lifetime capital gains exemption, increasing the adjusted cost base of the preference shares. This reduces any future capital gains tax liability on a subsequent sale of the shares or on the deemed disposition of the shares at death.
After the share exchange, the successor can subscribe for new common shares for a nominal amount, which will allow the successor to benefit from the future growth of the company. The business owner can maintain control of the corporation by receiving preference shares with voting control.
Role of life insurance
Life insurance can play a key role in funding tax liabilities arising on death, whether a business has been sold during the business owner’s lifetime or passed on to a successor. Life insurance may provide liquidity to redeem shares held by a former business owner and integrate with post-mortem planning to avoid the potential for double taxation. Life insurance may help equalize an estate where a business is passed to certain family members and not others. Life insurance may also be considered as an alternative asset class by individuals who have sold their business and continue to hold the sale proceeds personally or within an investment corporation. In many of these circumstances, life insurance can result in higher net estate values because of the beneficial tax treatment of life insurance: taxdeferred growth, tax-free death benefits and addition to a corporation’s capital dividend account in respect of life insurance proceeds that can be paid to shareholders as tax-free capital dividends