What is the capital gains exemption?
Canadians who own small businesses (Canadian-controlled private corporations), including farming and fishing businesses in some cases, are entitled to a capital gains exemption (in the form of a deduction for income tax purposes). What this means is that when you sell your business, you do not have to pay tax on up to about 50% of the proceeds. That could save you as much as $200,000 in tax.
How does it work?
There is a lifetime limit to the capital gains exemption, but you don’t have to use it all at once. In 2017, the lifetime limit is about $867,000 (it’s $1,000,000 for some farming and fishing businesses).
Your business must meet three criteria to be eligible for the capital gains deduction:
- No one other than the owner of the business, or someone related to the owner, can have held the shares of the business for two years before the shares are sold. The shares can be newly issued within the past two years, as long as no one else has owned them.
- 50% of the business’s assets within the past two years must be used for operation of the business in Canada.
- 90% of assets (what the Canada Revenue Agency refers to as “substantially all”) must be used for operation of the business at the time of sale.
Examples of assets not used for operations are investments and excess cash.
“Purify” to meet the requirements
If your business does not meet the requirements, you can “purify” the business so that the capital gains exemption will apply when you sell it. Purification is simply restructuring the business – such as by selling shares or changing what you use the company’s assets for – to meet the requirements and then waiting the required amount of time. So you are well advised to plan ahead to maximize your exemption.
Another way to move money during a purification restructuring is to set up a pension plan. If the business has been paying a salary to one or more family members working in the business, setting up the pension plan for them will allow for a buyback of past service. The buyback could mean that enough cash gets moved out of the business to reduce the business’s assets on hand and thus bring the business within the exemption requirements.
It is often better, however, to regularly move assets not being used in operations (retained earnings) out of the business. That way, you’ll be prepared if something unexpected happens that triggers a deemed disposition of shares – such as the death of a shareholder.
Examine other strategies
With your tax advisor, also look into the use of a trust to enable more family members to use their own lifetime capital gains exemptions.
Another strategy is to take advantage of the exemption at a particular time when your company meets all the requirements (“crystallize” your exemption), thus freeing you of the future need to continue meeting the exemption requirements “just in case.”
Get some advice
Ensuring that your business meets the capital gains exemption requirements can be complex and it requires advance planning. The best way to ensure that everything is correctly in place is to get professional advice from a qualified tax planner or chartered accountant.