If you are a small business owner and you are in your early 60s or older, have you given any consideration to the manner in which you will deal with the business when you wish to retire? This is a matter of great importance whether you intend to sell the business to family members, employees or a third party. You want to ensure that in order to obtain the greatest net after-tax dollars, the transaction is structured in the most efficient tax manner.
It is common for a family business to be transferred to the next generation. This may arise if one or more of the children are already involved in the business and have expressed an interest to continue working in it. Or, it may arise if one or more children are interested in becoming involved in the business after possibly doing something else, or after obtaining experience either with a competitor or in another type of business altogether. A question that sometimes arises is, what are you to do if not all of your children are involved in the business, or even if they all work in the business, but you are of the opinion that one is more capable of carrying on and growing the business than the others? How do you treat them equally from an estate planning perspective in order to avoid future tensions and issues between you and your children and among the siblings?
If you are dealing with your children as parties in the disposition of the business, you have several options available to you. These include selling or giving your shares to your children. You may initially be inclined to gift your shares to only those children who are already involved in the operation of the business equally; alternatively you may choose to gift your shares (whether equally or not) to all of your children, even those not involved in the business. In my opinion, this is not a good idea and may result in future family problems and issues. I have seen this result too often!
Finally, the gifting option is only feasible if you will not require the money you would receive from a sale of the company to a third party.
The route of gifting or even selling shares at a non-fair market value will result in income tax issues that need to be carefully considered in order to minimize the income tax, which becomes payable as a result. Pursuant to the income tax rules, Canada Revenue Agency will take the position that you gifted the shares at a value equal to the fair market value of the shares as of the date of gifting. The gain, which is based on the difference between the cost of the shares and the deemed fair market value, is subject to tax on 50 per cent of the gain taxable at your own rate of taxation in the year the shares were gifted or were sold below fair market value.
If you sell the shares to your children, as a good parent you will want to give them a good deal on the price. This well-intentioned gesture may result in a double-whammy of taxes under the provisions of the Income Tax Act: the rules dictate that if you sell shares to a related party you are treated as having received monies equal to the fair market value of the shares, while the children will be treated as having a cost base for the future determination of any capital gains, based on the price actually paid by them to you.
To paint a clearer picture, if your business is worth $4 million but you sell it to your children for only $500,000 and they, at a future date, sell it for $6 million, they will pay tax on the $5.5 million capital gain. Meanwhile, assuming your cost in acquiring your share was only $1 because you started the business, you would be paying tax on a deemed gain of $3,999,999. You and your children will ultimately both pay a major amount of income tax.
There are two methods that can be implemented to help reduce, if not totally eliminate, income tax, or at least help defer the payment of the tax owing. First, if you sell your shares to your children and take back financing (a promissory note for the total proceeds of sale payable over a 10-year term) you can defer the tax payable, and have the tax payable stretched out over a 10-year period based on the provision of the Income Tax Act permitting a reserve for amounts not yet due from the proceeds of sale.
The other route that may assist you in avoiding taxes completely, or in significantly reducing the tax payable, would be to claim the $750,000 lifetime capital gains tax exemption. This exemption is available when the shares of an active Canadian Small Business Corporation are sold; in other words, up to a maximum of $750,000 of the capital gains would be exempt from taxes payable. This is also contingent on you not having used up your $750,000 capital gain exemption previously.
This type of planning must involve both your accountant and your lawyer. You should commence the process as early as possible.
Toronto lawyer Martin Rumack’s practice areas include real estate law, corporate and commercial law, wills, estates, powers of attorney, family law and civil litigation. He is co-author of Legal Responsibilities of Real Estate Agents, 3rd Edition, available at www.lexisnexis.ca/bookstore. Visit Martin Rumack’s website at www.martinrumack.com.