Taxes can have a significant impact on the proceeds realized from the sale of a business. In this article, we highlight some of the most important tax considerations for anyone planning to sell their business, whether that’s in the near future or years ahead. Involving an experienced tax advisor well in advance of the sale can help business owners achieve the maximum after-tax result.

Asset vs. share sale

It will generally be to the business owner’s advantage to structure the sale of their business as a share sale. Where the fair market value of the shares sold is greater than the cost of the shares, the business owner will realize a capital gain from the sale. A share sale may allow the business owner to use the lifetime capital gains exemption (discussed further below) or unused capital losses to reduce the tax they pay.

In contrast, an asset sale will continue to result in a business owner having two potential levels of tax—corporate tax, from the sale of the assets, and personal tax, when funds are withdrawn from the corporation. The business owner will also have an ongoing obligation to file corporate tax returns unless the corporation is wound-up after the sale.

Understanding the preferences of potential purchasers will also help vendors in the negotiation process. Purchasers will generally have a preference to purchase the assets of a business rather than shares. Where assets have appreciated in value, the purchaser will benefit from larger tax deductions in the future if the business is acquired in an asset transaction. The purchaser may also be more comfortable from a risk perspective in acquiring assets, since that leaves any existing liabilities of the corporation with the vendor.

A key takeaway is to recognize that a $1,000,000 offer to purchase the assets of a business, for example, is unlikely to represent the same after-tax result as a $1,000,000 offer to purchase the company’s shares. If a purchaser proposes an asset transaction, the tax cost to the vendor should be considered in the negotiation. The option for a hybrid transaction (combining elements of both asset and share transactions) may also exist.

Capital gains exemption

The lifetime capital gains exemption (LCGE) is available to individuals that sell qualified small business corporation (QSBC) shares. As of 2023, the LCGE is $971,190. For taxpayers in the top marginal tax bracket in Alberta, this represents tax savings of approximately $230,000. 

In order to qualify for the LCGE, three tests must be met: the determination time test, the holding period test and the nature of assets test. Generally speaking, this means that:

• Ninety per cent of the fair market value of the assets in the corporation must be used in active business in Canada at the time the shares are sold.
• The shares must have been held by the seller or a related person for 24 months.
• During the 24 month period prior to sale 50% of the fair market value of the assets in the corporation must have been used in active business in Canada.

This two year time period for the QSBC tests is just one reason to consider speaking to a tax advisor about business succession well in advance of any sale. A tax advisor can help you determine whether a company’s shares are QSBC shares. If the business assets today do not currently meet the required thresholds, a tax advisor can help you develop a plan to increase the active business asset percentage (commonly called “purification”).

Some purification strategies include selling passive assets and using excess cash to reduce debt or to purchase additional active business assets. Purification can also have non-tax benefits like removing redundant assets from a corporation that a buyer may not want to acquire. There may also be an opportunity to access multiple capital gains exemptions where other family members, like a spouse or children, are shareholders in the business.

Alternative minimum tax

The alternative minimum tax (AMT), as its name suggests, is an alternate way to calculate taxes to ensure that high income earning individuals pay a minimum amount of tax when benefiting from certain deductions, including the LCGE. Taxpayers must pay the higher of AMT and “regular” taxes in a given year. Where AMT is the higher amount, the amount paid in excess of “regular” taxes can be used to reduce taxes for the next seven years. By understanding the impact that AMT can have on the sale of a business, you can avoid surprises during the sale and ensure necessary cash is available.

Capital gains reserve

In some transactions, the vendor may agree to receive the sale proceeds over a number of years. When a sale is structured this way, the vendor will have the option of deferring a portion of the capital gain realized on the sale by claiming the capital gains reserve. Generally, at least 20% of the capital gain must be reported in the year of sale and each of the four following years.

Transferring the business to the next generation

Estate freeze

An estate freeze refers to a transaction that “freezes” the value of the ownership of existing shareholders, with any future growth of the company’s value accruing to a new shareholder. This may be useful when the business succession plan is for the current owner’s child or children to take over the business. The next generation may not have the ability to purchase the company outright and it may not be the parents’ intention that they do so.

To implement an estate freeze, all existing common shares in the company would be exchanged for preferred shares with a cost equal to the current common shares and a redemption value equal to their current fair market value.A newly established family trust in which the child or children are beneficiaries would then subscribe for new common shares in the company. Alternatives to this include:

• The child or children holding the new common shares directly.
• The parent subscribing for a portion of the new common shares and continuing to benefit from some portion of the future growth in the company. This is referred to as a “partial estate freeze.”

After an estate freeze, the preferred shares can be redeemed by the corporation over time to provide the parent with funds from the company on a regular basis. These redemptions would result in deemed dividends. Where the parent does not require funds from the corporation, the preferred shares could simply remain outstanding and ultimately upon death, a deemed capital gain would be realized.

An alternative may be for the child or children to purchase the shares. For those considering this approach, please refer to our article, 2023 federal budget: new rules for 2024 impacting business succession planning.

Start tax planning early

76% of Canadian business owners intend to exit their businesses in the next decade. If you are in that group, whether you plan to sell your business on the market or pass it to the next generation, we recommend that you include tax planning in your succession plan.