The Lifetime Capital Gains Exemption: Plan ahead

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People often ask me about the Lifetime Capital Gains Exemption (the “LCGE”), which for the 2015 tax year is $813,600, and many just assume that any capital gain can be covered under the exemption.  

Actually, the LCGE allows one to dispose of Qualified Farm Property, Qualified Fishing Property, or shares of a Qualified Small Business Corporation and not pay any capital gains tax on the first $813,600.  And as the wording suggests, there are qualifications.

In general only ½ of a capital gain is taxable, and with the LCGE, the 2nd half can be non-taxable too up to $406,800 (in 2015) – by virtue of a capital gains deduction.

With many people either actively in the process of selling their business or planning for this eventuality, there is a great deal of confusion as to what kinds of sales would be subject to the LCGE, and thus many people don’t take the necessary steps to protect themselves, which can cost hundreds of thousands of dollars.

The Qualified Small Business Corporation

A gain from the sale of shares of a Canadian controlled private corporation can qualify for the LCGE if a number of conditions are satisfied; one of those being that at the time of sale, all or substantially all of the assets (90%+) of the business are used principally in an active business carried on primarily in Canada.   

What this means in practice is that the in the course of an audit the LCGE could be at risk if the Canada Revenue Agency discovers that at the time of sale there was too much cash on hand or that there were too many assets such as stocks, bonds, investments, and rental properties not being used in the active business.  So before selling shares it is crucial to evaluate both the active and inactive business assets and take necessary steps to “purify” the corporation or to divest the company of any excess assets prior to sale.  This can be done through various methods such as a reorganization where inactive assets are spun off as a separate corporation or a dividend to shareholders.

And since a controversy could erupt years later with respect to the valuation of assets at the time of sale, it would be prudent to have a proper appraisal report prepared by a professional. This is your insurance policy.

Other than the requirement governing the use of assets in active business is a requirement pertaining to the ownership of the shares in the preceding 24 months.  In order to qualify for the LCGE, the shares being sold must not have been owned by anybody other than the taxpayer or a related person or partnership in the 24 months preceding the sale.  This is not to say that the shares must have been held for 24 months; in fact the shares can be newly issued.  It is just that no other non-related party can have held the shares in the 24 months preceding the sale if the LCGE were to be claimed.  

Active Business

As eluded to above, in order for the LCGE to apply, the business must be an active business, which rules out several types of businesses – “Specified Investment Business”, “Professional Services Businesses”, and holding company-type businesses, because the income derived by these types of businesses does not fall under the definition of “Active Business Income”.  

And besides the LCGE, Active Business Income earned by a Small Business Corporation has another benefit -  the first $500,000 qualifies for the Small Business Deduction (“SBD”) which results in a lower tax rate than usual.  

Specified Investment Business

Not giving rise to Active Business Income, Specified Investment Businesses are those businesses with the primary purpose of deriving income from a property (rent, royalties, interest, dividends). Since the income from these businesses is not active, it does not give rise to either the SBD or the LCGE, and the decision to disqualify these businesses was to prevent taxpayers from sheltering investments in corporations where they are taxed preferentially.

There is an exception to the Specified Investment Business rule however, and that is when the business employs “more than 5 full time employees”, which has been interpreted as at least 5 full-time employees and one part-time employee (Lerric Investments Corp. v. The Queen, FCA 2001).  Thus shareholders of  bona fide businesses, actually active in the business of deriving income from property are not unfairly treated simply because of the nature of their business.

Professional Services Business

Also not giving rise to Active Business Income, the Professional Services Business (“PSB”), also called the “Incorporated Employee”  by some, is a business in which an individual provides their services to a company through a corporation.  In order to prevent an individual from shielding their employment income in a corporation, these corporations are denied the SBD and the LCGE does not apply.  Further, there is a strict limitation in terms of the types of expenses which can be deducted, making it that much less attractive a vehicle. 

Even still, there may be other advantages to operating a PSB such a deferring tax by keeping earnings in the corporation, or by income-splitting to a spouse via eligible dividends.  

Asset Sales vs. Share Sales

For many reasons, in the course of the acquisition of a business, rather than purchase the shares of the corporation, the buyer frequent chooses only to acquire the business’ assets.  And while an asset sale does not give rise to a gain to which the LCGE can be applied, there are other ways to reduce the tax payable in such a sale.

In the course of the asset sale, the non-taxable portion of the capital gain on the disposition by the corporation of capital property is deposited to the Capital Dividend Account (“CDA”), and can be distributed as non-taxable dividends to the shareholder.  In fact the account should be distributed quickly if there is a chance that in the future there could be a capital loss which would erode the CDA balance. 

And even if a business only sells its goodwill, such a sale could constitute the sale of Eligible Capital Property, which similarly would give rise to an increase in the CDA and thus the possibility of a tax-free dividend to the shareholder.

Concluding Remarks

When you are thinking of selling your business or its assets, not only is it vital to remember to plan ahead, but it is also important to remember that rules are fluid.  And particularly with the change in Federal Government it is possible that your planning from last year may need some adjusting.   Tax rates could change; the Small Business Deduction could change; the LCGE limits could change, and any other provision of the Income Tax Act could change, making your planning less efficient, or even obsolete. So it is prudent from time to time to re-examine one’s position.

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Dale Barrett is the Bestselling author of “Tax Survival for Canadians: Stand up to the CRA” and the managing lawyer of Barrett Tax Law – a national boutique tax law  firm providing service in English and French with expertise in resolving complex tax disputes at every level and dealing with collections, non-filing and voluntary disclosures. More information on Barrett Tax Law is available at www.FightTheCRA.ca

Dale, whose practice focuses on tax litigation and working with accounting firms to find solutions to address their clients’ needs, is a graduate of the McGill University joint common law / civil law program. You can contact Barrett Tax Law directly at (866) 278-8424 or via email at info@barretttaxlaw.com.

Disclaimer

This posting is for informational purposes only and neither constitutes legal advice nor creates a lawyer-client relationship.

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