As a small business owner, not only should you plan for your business but also your personal tax situation. Your business is a large part of what you do and your net worth. Therefore, you must know all the tax planning strategies you can use as a small business owner. Whether you are thinking about an exit strategy or are planning for the future, understanding the impact of your business on your situation can help prepare you for future opportunities. A particular tax planning strategy for small business owners in Canada involves using the Lifetime Capital Gains Exemptions (“LCGE”). This exemption can allow business owners to sell their shares in a business without triggering significant taxes on capital gains.
We go over the basics of this exemption and provide examples of how business owners can use this exemption to plan for the future.
What is the Lifetime Capital Gains Exemption?
The Lifetime Capital Gains Exemption (“LCGE”) is a cumulative, once-in-a-lifetime tax deduction available for every Canadian resident. In 2022, this amount is $913,630, which is indexed to inflation annually.
Typically, the sale of a business, where you make a profit, triggers capital gains. For example, if you sell your business for a profit of $900,000, a taxpayer will generally pay taxes on half the profit or $450,000, otherwise known as the taxable capital gain. At the highest marginal rate, this would trigger a tax bill of $241,000.
If you are a Canadian tax resident who sells shares of Qualified Small Business Corporation (“QSBC”) shares, you can qualify for the LCGE, which would allow you to shelter taxable capital gains up to your available deduction limit. For a taxpayer who has their full LCGE available in the above example, they would save the entire tax bill of $241,000.
How to qualify for the Lifetime Capital Gains Exemption?
To qualify for the Lifetime Capital Gains Exemption (“LCGE”), you must be a Canadian tax resident with an available balance in your LCGE account. In addition, the business you sell also needs to qualify as a QSBC (or another qualifying business) for the exemption.
For a business to qualify as a Qualified Small Business Corporation (“QSBC”), it must meet three following tests:
1. Small Business Corporation Test
The business in which you own the shares must be a “small business corporation” when you sell it. This means that it should be a Canadian-Controlled Private Corporation (“CCPC”), and the business must use its assets in an active business carried primarily in Canada.
2. Holding Period Test
You or someone related to you must own the shares of the business in the last 24 months for it to qualify for the exemptions.
3. Fair Market Value Asset Tests
In the 24 months before the sale, more than 50% of the fair market value of its assets was used in an active business, primarily in Canada and at the time of the sale, more than 90% of the fair market value of its assets should have been used in an active business.
Three common tax planning strategies to qualify for LCGE
Tax planning involves proactively looking to the future and preparing for any opportunities you might want to take on.
Whether or not you can use the LCGE relies heavily on whether the business meets the tests set out by the CRA.
If you are a small business owner, a good starting point can be to evaluate whether or not the business you own qualifies as a QSBC at this point. A tax accountant or advisor can help walk you through the tests and determine if the shares would be eligible for the LCGE.
Once you know whether or not your business meets all the conditions, you can decide your plan of action if you do want to take advantage of the Lifetime Capital Gains Exemption. We go through three popular strategies that help you take maximum advantage of the exemption.
Crystallize your QSBC Exemption
If you are in a position where you have determined that the business qualifies for QSBC, under all three tests, you can “crystallize” the gains, for example, in an estate freeze.
This allows you to trigger a capital gain when you know that the shares qualify for the exemption without actually disposing of their shares. In effect, you increase the cost base of your holdings. If you sell it later on, you can minimize your capital gains, even if the business no longer meets one or more tests in the future.
By doing so, you manage future uncertainty of the business, knowing that you were able to take advantage of the Lifetime Capital Gains Exemption.
Multiply QSBC Gains Exemption
Tax planning, when done holistically, as a family unit, can be a great way to protect and grow a family’s wealth today and in future generations.
Each individual family member has access to the LCGE. One way a family can benefit from the LCGE is to structure the business to allow multiple family members to use their exemptions at the time of sale.
Proactive tax planning strategies can allow you to make elections and structure your finances to benefit you and your family.
Qualify your business into a QSBC
If your business does not meet the QSBC tests at the moment, but you want to take advantage of this exemption, looking at how your business can qualify can be an excellent way to plan for the future.
Some businesses may not qualify because they do not have enough active assets employed in the business. Adjusting the business’s use of active vs. passive assets can be a strategic part of tax planning if it is also in the company’s best interest.
This way, you are ready to seize any opportunities that may come your way.
Tax planning for the future
As a business owner, you must be ready to take on opportunities when they come your way. You never know when you get a tempting offer to sell the shares of a profitable business.
Being proactive with your tax planning is one way to be prepared for the future. In addition, tax planning strategies can help you save money in the long run by either qualifying for significant capital gains exemptions like this or tax deferral strategies that can help you build wealth for the future.
Contact KSSP Partners LLP in Markham for all your Tax Planning Needs
Talk to an experienced Canadian tax professional to optimize your tax situation. At KSSP Partners LLP, our business and tax advisors can provide personalized tax planning advice for your personal and business taxes. To learn more about how KSSP Partners LLP can provide you with the best tax planning expertise, contact us online or by telephone at 289-554-5997.