Tax issues to avoid when preparing your exit strategy
All too often, business owners neglect to plan ahead for the succession of their business. And while this is likely to affect their options for transitioning out of their business, there can also be severe tax implications that could have been avoided with a bit of forethought and advance planning.
In many cases, the ultimate tax burden on the taxation of capital gains resulting from the sale of a business can severely impact the retirement plans of the owner. For example, let’s assume that your business is sold for $3,000,000 and had a minimal cost when it was started. Prior to the sale it was solely owned by you, and you are still able to utilize your $750,000 capital gains exemption. The result would be that the amount of $2,250,000 would be subject to tax at a rate of about 23%, resulting in tax payable of $517,500, and net proceeds to you of $2,482,500.
However, with proper advance planning, it is possible to eliminate or significantly reduce the tax on sale. This is done by having other family members (spouse, children, or a trust for spouse and/or children) owning shares of the company which participate in the growth of the business. For example, if at the time the business was started, each of the husband, wife, and two children owned an equal number of shares, then the sale of the business for $3,000,000 would result in NO TAX, as each of the four shareholders would be able to utilize their individual $750,000 capital gains exemption. This is the ideal scenario, but even if the ownership of the business was not structured in this way from the beginning, it is still possible to change the structure to enable future growth in value to go to the new shareholders.
Let’s say that you are the sole owner of the business, which is worth $750,000 today. You want to implement a plan to save tax on the capital gains when you sell the business a number of years down the road. This can be accomplished by changing your common (growth) shares into new preference shares that have a “frozen value” of $750,000. These preference shares can be voting shares, so that you still have voting control of the company. New common shares can now be issued to your spouse and (let’s assume) two children, or to a trust for either or both of these parties.
Initially, these new common shares will have no value. However, over time, as the value of the business continues to increase, all of the growth in value will go to these new common shares, as you “froze” the value of your shares when you transferred them to preference shares. Using the same scenario as in the first example, if the business grows to a value of $3,000,000 prior to sale, then the value of the shares of all four parties is $750,000 each – your “frozen” preference shares, and the growth of the common shares to a value of $2,250,000, which is then split between your spouse and two children.
These are simple examples of how advance planning can result in significant tax savings upon the sale of the business. In addition to these plans which can produce huge savings in the future, many of these structures provide an immediate tax advantage by permitting income splitting through the payment of dividends to the new shareholders.
Unlike salaries, there is no requirement for the shareholder to be actively involved in the business in order to receive dividends. In our experience, many businesses attempt to “income split” by paying salaries to spouses or children who have little or no involvement in the business. Recently, Canada Revenue Agency (CRA) has started calling businesses that are paying salaries to spouses, and asking the receptionist if they can talk to “Mrs. X”. Guess what happens when the receptionist says: “Oh, that’s the owner’s wife. She doesn’t work here!” The result of this conversation can be extremely punitive. Not only will CRA disallow the deduction of the salary by the company, but they may NOT remove the income from the tax return of the recipient! Being taxed on income once may not be fun, but you can imagine how it feels to be taxed on the same income twice!
It is extremely important that you involve professional advisors in any restructuring of the business. The tax planning must be done properly in order to be deemed acceptable to the CRA and thus avoid the many pitfalls that result from faulty tax planning.
For more information, please contact Mitch Silverstein, Partner at SBLR LLP Chartered Accountants at 416.488.2345 x 274 or at email@example.com. SBLR is a full-service accounting and business advisory firm located in mid-Toronto. With 9 partners and over 40 team members, including a strategic tax department, SBLR specializes in providing creative income tax solutions and high-level growth and exit strategies for profitable, privately-held companies.
Financial Tip… from James Phillipson
One of the most significant keys to success in a business is the succession planning process. In the same way as one cannot measure the gain on stock that one owns until it is sold and the gain realized, one should wait until the founder of a business has “exited” to measure the success. Whether that exit is a transfer of ownership within the family or a sale to third parties, the success will be very significantly affected by the planning and implementation of that plan. One key aspect that has been very well illustrated in the article above, that is among the easier succession planning strategies, is to ensure that you have an appropriate and effective income tax structure. As is also well illustrated in the article, the timing of implementation can make a huge difference. It is too late to start thinking of income tax when you start to focus on selling the business. Many of the opportunities will have been missed or be worth much less than they could have been if implemented earlier. So don’t procrastinate.
About the Author James Phillipson is a Chartered Accountant and a Principal of Mastermind Solutions Inc. with over twenty years experience in large and small businesses. He has provided financial counselling to his clients since 1996, often in the role of a Controller or Chief Financial Officer. James has experience in financial roles in a wide variety of businesses and industries.
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