What Income Tax Rate(s) Should You Use in Estimating Your Estate Tax Liability?

In my last blog post, I discussed that for tax and estate planning purposes, you should estimate your current estate tax liability and then plan how your estate will cover off this liability (which in many cases is an ever growing tax liability). Today, I want to discuss what income tax rate(s) you may wish to use in estimating your estate tax liability.

For clarity, this exercise to estimate your estate tax liability is not meant to be definitive calculation (if you wish a definitive calculation, you will need to engage your accountant and possibly a business evaluator). This exercise is intended to provide you with a starting point, so that you have a number to plan with, whether your intention is for your estate to cover off this potential tax liability by a sinking fund, cash on hand, liquidation of your assets, insurance or some combination of all of the above.

One would think the income tax rate(s) to be used in estimating your estate tax liability would be a straightforward calculation, but there is a little more than meets the eye. Please keep in mind, that I am assuming you are the last spouse to pass-away for this estimated calculation, as if you are the first spouse to die and transfer your assets to your surviving spouse, there is no tax at that point in time.

For RRSPs, RRIFs or any other income related items taxable on death, I usually use the highest current marginal rate of 53.53% (in Ontario). This assumes your estate’s income tax rate is mostly high rate in the year of death. While that is typically the case with most of the people I work with, that may not be your case and you may be able to utilize a lower marginal tax rate, but if you want to be conservative, the highest marginal rate builds in a buffer.

As most people like to think/hope personal marginal rates will not increase much in the future (although many of us thought the same when rates were 45%), they are comfortable using the current 53.53% rate for a future rate on income type items.

Things become trickier when determining the appropriate tax rate to use on capital items. The highest current marginal capital gains rate is 26.76% (in Ontario). However, many people assume capital gains rates are going to increase in the future, so the rate to use is not entirely clear. Thus, I typically provide an alternative estimate using 26.76% and another using 40% assuming a higher future capital gains inclusion rate of 3/4 of the capital gain (as opposed to the current inclusion rate of 1/2 of the capital gain) for capital gains rates on personally held assets. If you do not expect your estate to be at the highest marginal rate on your death, you can use the lower marginal rates; but remember, the inclusion of your RRSP/RRIF value on your death will in many cases move you into a much higher income tax bracket. 

The future capital gains rate is even more complicated for shareholders of private corporations, since their shares are potentially subject to double taxation if proper steps are not undertaken to alleviate this liability. Double taxation can occur where the estate pays tax on the deemed disposition reported on the owner’s terminal tax return, and then the estate pays further tax when it removes the assets from the corporation in the form of dividends to the estate. 

There are two tax planning strategies that can generally eliminate any double tax; however, both techniques have some potential restrictions:

(1) The first is known as a subsection 164(6) loss carryback. In simple terms a loss is created on a share redemption by the estate that reduces or eliminates the capital gain that arose as result of the deemed disposition on death.

(2) The second, known as the pipeline strategy allows the estate to remove the corporate funds generally tax-free. This is achieved by transferring the deceased owner’s shares to a new corporation and using share redemptions and a netting of promissory notes to remove those funds tax-free.

However, a pipeline strategy can be problematic in certain circumstances and the strategy relies upon the CRA allowing such a strategy in the future. This makes determining a future capital gains rate potentially problematic. So, when I prepare my estate tax liability, for private corporations I use a 30% rate as a low-end and a 40% rate as a high-end estimate (Note: unlike above, I am not using the 40% rate because of the prospect of a capital gain rate inclusion increase, but as a dividend rate if a pipeline cannot be undertaken or is partially blocked).

If your private company shares qualify for the lifetime capital gains exemption because they are Qualified Small Business Corporation shares, you will need to factor in the fact that $971,190 (as of 2023) of the capital gain will not be taxable. 

Finally, the tax rate on a private corporation share can also be impacted by corporate attributes such as the Capital Dividend Account and refundable income taxes on hand (NERDTOH and ERDTOH), which again makes it more difficult to determine the appropriate income tax rate. Where your corporation has these tax preference items, your accountant needs to undertake more detailed calculations. 

The question of which tax rates should be used for an estate tax liability estimate is somewhat complicated as discussed above and subject to future taxation legislation and government policy. Thus, as noted above, I personally provide clients with two estimates: (1) Using the highest marginal rate for income items and a 30% capital gains rate and (2) a second more conservative estimate using the highest marginal rate for income items and a 40% capital gains rate. This at least provides a range of their potential future estate tax liability. 

For purpose of this blog, I am hoping/ignoring the possibility that a future government implements an Estate Tax like that in the United States (the estate tax can go as high as 40% Federally subject to exemptions) as that would significantly affect any future tax liability planning.

Finally, as the above discussion is premised on estimates, please ensure you consult your accountant or estate planning specialist for specific estate planning advice and the determination of your estate tax liability. This advice should be obtained earlier rather than later and then reviewed every few years thereafter as personal circumstances change and new legislation is introduced.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Best of The Blunt Bean Counter - Business and Income Tax Issues in Selling a Corporation

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game (I will be back to regular posting next week). Today, I am re-posting a June 5, 2012 post on the issues in selling your corporation. This post is as pertinent today as it was three years ago when first posted (Note: I have updated any time sensitive numbers and tax changes).

I cannot stress how emotionally taxing the sale process is for someone who has never gone through it before. I dread when a client tells me they are selling their business, as I know the next few months will be very stressful for them (and indirectly me) as they just don't have the experience of going through the "sale dance". Hopefully if you are selling your business, some of the tips below can at least prepare you for the issues and tension to come.

 

Business and Income Tax Issues in Selling a Corporation

 

The sale of your business/corporation is typically a once in a lifetime event. Thus, in most cases, you will never have experienced the anxiety, manic ups and downs, legal and income tax issues, negotiating stances, walk-away threats and all the other fun that comes with the experience.

In order to navigate the sale minefield and to come up with a fair negotiated deal, you will require a team that includes a strong lawyer(s), accountant and maybe even a mergers and acquisitions consultant. 

With all that to look forward to, I figured I would provide some of the meat and potato issues you will also have to solve and negotiate.

Assets vs. Shares

In general, the sale of shares will yield a better return for the seller than the sale of assets, especially if the vendor(s) have their $813,600 (indexed yearly for inflation) Qualifying Small Business Corporation (“QSBC”) capital gains exemptions available. However, the purchaser in most cases will prefer to purchase the assets and goodwill of a business for the following two reasons:

(1) The purchaser can depreciate assets and amortize goodwill for income tax purposes, whereas the cost of a share purchase is allocated to the cost base of the shares

(2) the purchaser does not assume any legal liability of the vendor when they purchase assets and goodwill; whereas under a share purchase agreement, the purchaser becomes liable for any past sins of the acquired corporation (of course, the purchaser’s lawyer will covenant away most of these issues as best they can).

Consequently, the purchaser typically wishes to buy assets whereas the seller wishes to sell shares and thus, the first negotiation point. Whichever way it goes, the buyer knows why you want to sell shares and will typically discount the offer when buying shares instead of assets.

Working Capital (“WC”)

WC is the difference between current assets and current liabilities and measures the liquidity of a company. In simple terms, working capital is cash plus accounts receivable and inventory less accounts payable. WC can be a huge bone of contention in any sale, but especially in an asset sale. The seller in most cases blissfully assumes they will keep all the WC and also get a multiple of the corporation's earnings as the sale price. The purchaser typically wants enough WC left in the business such that they will not need to finance the business once they have made the initial purchase and contributed whatever cash or line of credit they feel is required upon the initial purchase.

The WC is a very esoteric concept at best and very hard for most sellers to grasp. Thus, it is vital to deal with this issue upfront and not leave it to the end where it can derail a deal, something I have experienced first-hand.

Valuation

Most sellers have valuation multiples dancing around in their heads like little sugar plum fairies. However, most industries have standard valuation multiples. For most small businesses the multiple is somewhere between 2 and 4 times earnings, with a higher multiple for strategic acquisitions, especially where the purchaser is a public company, since they themselves may have a 15 to 20 multiple.

For many acquisitions, especially by public and larger corporations, the multiple is based on Earnings before Interest, Taxes and Amortization (“EBITA”). However, in addition to EBITA, there will be adjustments to the upside for management salaries in excess of the salary that would be required to replace the current owner (typically you are adding back bonuses paid to the seller in excess of their monthly wages and any other family wages). Occasionally the adjustment could be to the downside, but that is typically only in situations where the business is a technology company or similar that is just starting to make money or finalize a desired product, and the owners wages have not yet caught up to market value. Finally, there will be other additions to EBITA for things like car expenses, advertising and promotion, etc. that a new owner would not necessarily need to incur upon the sale.

Where a purchase is made by a private company, instead of EBITA, the price may be based on a capitalization of normalized after-tax earnings or discretionary cash flows.

Retention

In most cases, the purchaser will require the seller to stay on for a year or two to ensure a smooth transition. The owner will thus be entitled to a salary for that period in addition to the sales proceeds. The retention period can go several ways, some blow up quickly, some end after the year or two, but often the former owner stays on as the business is now growing due to additional funds or more sophisticated management and they enjoy remaining with their baby without the stress of ownership.

 

Continued Ownership

 

It is not uncommon for a purchaser to require that the seller maintain some ownership in their company so that they still have some “skin” in the game, especially when they will be staying on with the business. This is also the case where the purchaser is consolidating several similar businesses with the intent of going public. In these cases, we counsel our clients to assume the worst (i.e. that the new owner will make a mess of the business) and to ensure they receive proceeds equal to or only slightly less than they initially desired. We have seen several disasters in consolidation purchases where the seller ends up with minimal proceeds after keeping significant share positions with the lure of the consolidated entity going public and the consolidated company just does not have the expected synergies.

Tax Reorganizations

 

Where the deal is a share purchase, often the current corporate structure is not conducive to utilizing the QSBC capital gains exemption, especially where a holding company is in place or the company being sold has a large cash position. As I state in this post, the capital gains exemption is not a Gimme. It is thus vital to ensure at least some initial income tax planning is done so that if the deal moves forward, proper consideration has been given to the income tax planning and the planning is not a wild last minute scramble.

I have only touched on a few of the multitude of issues you encounter upon the sale of your business. As noted initially, it is vital to understand the process and how stressful it may be from the start, and to assemble the proper team to help you navigate through the sale process.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Holding Companies – Issues to Consider

I have written several blog posts dealing with utilizing a holding company (“Holdco”) either directly as a parent company to your operating company (“Opco”) or indirectly as a beneficiary of a trust. These posts include:

Creditor Proofing Corporate Funds - This post discusses how a Holdco can protect surplus corporate funds and how for income tax purposes, the transfer of funds via a dividend from your Opco to the Holdco is in many cases tax-free (connected corporations).

Should Your Corporation’s Shareholder be a Family Trust instead of a Holding Company? - This blog examines some “fancier” tax planning to not only creditor proof funds, but allow for possible income splitting and multiplication of the capital gains exemption.

Corporate Small Business Owners: Beware; the Capital Gains Exemption is not a Gimme - This post explores the potential issues you may have in accessing the Capital Gains Exemption (“CGE”) including where your Holdco over time has accumulated too much cash and investment assets.

Because the concepts discussed in the blogs above are very complex (even for accountants), these posts have led to numerous questions by readers. In reading these questions, people are typically confused by the interaction of creditor proofing, income splitting and accessing the CGE, especially where they already have a Holdco in place with significant excess cash and/or investment assets. Thus, I thought today I would try and provide a bit of a road map for using a Holdco.

Working Backwards

Creditor Protection

The main reason small businesses owners typically consider using a Holdco in the first place is to creditor protect excess funds earned in their operating company. Most people find the concept of creditor protection (transferring cash and other assets from your Opco to remove the risk of someone suing Opco and making a claim on those assets) simple to grasp and in almost all cases; it makes business and income tax sense. Thus, I am assuming creditor protection is a given when considering using a Holdco.

Capital Gains Exemption

Where you do not think you can sell your business (the value of your business is just personal goodwill such as in a consulting business) a standard holding company often makes sense.

Where Holdco planning gets more complicated is when you want to ensure you have access to your CGE (while alive or when you pass away) and/or want to multiply the exemption and/or want to use your Holdco for income splitting purposes. The key concept to understand here is that; to access your CGE you or a family member must personally sell the shares of your Holdco (since you own the shares of your Holdco which in turn owns your Opco) and Holdco must meet various criteria to qualify for the CGE. If you have your Holdco sell the shares of your OPCO, there is no CGE, since it is a corporation selling, not an individual.

Situations Where you do not Currently have a Holdco in Place

If you currently own 100% of your Opco or own your Opco together with your spouse, you have a couple decisions to make before incorporating a Holdco.

Again, assuming creditor protection is a given, you need to determine if you think you will be able to access the CGE in the future. If the answer is no, you will probably be fine with a garden variety Holdco (Holdco owns 100% of Opco) especially if you already own Opco with your spouse.

Where you own Opco 100% personally and do not think you can access the CGE, you may want to give consideration to freezing (value of Opco is “frozen” at the current fair market value and you get special shares worth the frozen value) Opco and bringing your spouse in as a shareholder in Holdco. Again, in this situation, you would probably just use the typical Holdco/Opco structure with Holdco owning Opco 100%; however, you would have to concern yourself with ensuring you are not subject to punitive income tax rules, for which you would need income tax advice.

No Holdco in Place, but You may be able to Sell your Company in the Future to Access the CGE

Where you think your corporation is saleable to an arm’s length person in the future, the standard Holdco/Opco structure may not be appropriate, as damming cash in your Holdco may put your ability to claim the CGE in jeopardy.

In these cases, subject to your specific circumstances and only after consulting with your tax advisor, you may use either taxable dividends, stock dividends, an estate freeze or some kind of butterfly (a reorganization in which non-qualifying assets are transferred on a tax-free basis to a newly formed corporation, provided that no sale to an arm's length party of the shares of the small business corporation is contemplated at the time of the reorganization) to provide a structure that will allow Opco/Holdco to either constantly remain onside the criteria for the CGE or at least provide a mechanism to stay onside. Based on the recent Federal budget, your advisor may have to concern themselves with your company's safe income, in addition to the punitive rules I noted above.

As discussed in the “Should Your Corporation’s Shareholder be a Family Trust instead of a Holding Company?”, where you have children (especially teenage children or older), it will often make sense to “freeze” the current value of your operating company to you and/or your spouse (if they have original ownership in the Opco) and have a family trust (with a holding company as a beneficiary of the family trust) as the parent of Opco.

Excluding the cost of undertaking this transaction, this structure can provide for multiplication of the capital gains exemption, income splitting (many parents use this structure to tax effectively pay for University) and creditor protection. The nuance here is that the Holdco is not the parent of Opco, but a beneficiary of the trust and therefore is not an impediment to accessing the CGE in the future. Once again, there are punitive tax rules to be wary of and tax advice is essential.

What if I Have a Holdco already in Place?

In situations where you already have a Holdco in place with significant assets, your planning is very complicated and fact specific and beyond the scope of this post. However, typically, subject to your specific fact situation, your advisor will likely suggest either a butterfly, freeze transaction, payment of a taxable dividend or use of a stock dividend that will allow for potential access to the CGE in the future. In cases of a freeze, this may mean you will be required hold the shares at least two years to qualify for the CGE.

I have attempted in this post to provide a bit of a road map for using a Holdco or a variation of a Holdco. However, this topic is extremely complex and fact specific and as such, I have not even got into the various punitive income tax provisions such as the corporate attribution rules amongst the various other punitive rules.

Thus, I cannot stress enough, that this entire blog is simplified and that you should not even consider undertaking any kind of Holdco planning without receiving tax advice from your accountant or tax lawyer.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Two Certainties in Life: Death and Taxes - The Impact on Small Business Owners

In my two prior blog posts in this series on death and taxes, I discussed with you the general income tax rules as they relate to the death of an individual. Today, I am going to discuss the income tax issues that arise on death, where you own shares in a private Canadian corporation (“CCPC”).

Note:You may own shares in a private corporation (typically a Canadian company controlled by non-residents) as opposed to a CCPC  or shares in a private foreign corporation. Although the general deemed disposition rule will apply upon death, for purposes of this blog post, I am not considering any issues related to these type entities. Please seek specific advice if you own such shares.

It has been my experience that some owner-managers of CCPC’s are surprised to find out that their shares are subject to the general deemed disposition rules upon death. The rule being: that upon your death, the shares of your CCPC (assuming the shares are not transferred to your spouse) are deemed to have been disposed of for proceeds equal to the fair market value (“FMV”) of those shares and a capital gain results to the extent that FMV (which is often difficult to determine for a CCPC) exceeds the adjusted cost base (“ACB”) of those shares.

There are two reasons I typically hear as to why the private company owner-manager does not think their shares are subject to the deemed disposition rules:

(1) They thought the corporate taxes they paid each year took care of that issue.

(2) They thought if they left the company to their children, their kids would be the ones who pay the tax (as per my blog on estate freezes, this tax can be mitigated, but not eliminated by undertaking an estate freeze).

The owner-manager may also be surprised to hear that their shares are potentially subject to double taxation if proper steps are not undertaken to alleviate this liability. Double taxation can occur where the estate pays tax on the deemed disposition reported on the owner-manager’s terminal tax return, and then the estate pays further tax when it removes the assets from the corporation in the form of dividends to the estate.

There are two tax planning strategies that can generally eliminate any double tax; however, both techniques have some potential restrictions:

(1) The first is known as a subsection 164(6) loss carryback. In simple terms a loss is created on a share redemption by the estate that reduces or eliminates the capital gain that arose as result of the deemed disposition on death. It should be noted that new legislation related to the changes to “graduated rate estates” could impact this planning in the future, as the loss carryback may be restricted.

(2) The second, known as the pipeline strategy allows the estate to remove the corporate funds tax-free by in very simple terms, transferring the deceased owner-manager’s shares to a new corporation and using redemptions and a netting of promissory notes to remove those funds tax-free.

However, a pipeline strategy can be problematic in certain circumstances.

Capital Gains Exemption

In many cases the owner-manager can avail themselves to the $800,000 capital gains exemption ("CGE") to utilize against any deemed capital gain. However, as discussed in this post, it can be problematic to access the exemption where the corporation has excess cash or the owner-manager dies suddenly without implementing the proper planning.

In summary, as morose as this sounds, if you own shares of a private corporation, you and your tax advisor should be proactively planning for your death, which includes monitoring on an ongoing basis, whether your shares will qualify for the CGE.

The planning process would in general start with a determination of your potential income tax liability on death, including an estimate of the liability related to your private company shares. This will lead to a discussion of whether or not your estate will have enough liquidity to cover that anticipated liability or if you need to consider purchasing life insurance to cover any taxes potentially owing upon your death. The discussion should then morph into a succession planning discussion, and whether or not an estate freeze/sale to family member would make sense in your situation, or what plans you have in regard to an exit strategy.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Corporate Small Business Owners: Beware; the Capital Gains Exemption is not a Gimme

One of the biggest misconceptions small business owners have is that they have automatic access to the $800,000 capital gains exemption (“CGE”) upon the sale of the shares of their corporations (Note: beginning in 2015, the $800,000 will be indexed for inflation). Nothing can be further from the truth. There are three complex tests that must be met in order to qualify for the exemption and something as innocuous as imposing a holding company (with significant cash and investment assets) between you and your operating company may disqualify the shares.

Warning!!! Before I move forward, please note that I am “dumbing down this post”. You may think it complex, but I am leaving out significant issues, definitions and details to make it somewhat readable. Do not rely upon this blog for your capital gains planning, use it only to gain an understanding of the issues and please contact your tax advisor before undertaking any planning discussed in this post. In fact, to emphasize the complexity of this issue and how intricate and fact related the planning is, I will not answer questions and respond to comments on this post. Sorry about that.

The Capital Gains Exemption

In order to access the CGE, the shares you sell must meet the definition of a "qualified small business corporation share” (“QSBC shares”). Sounds simple, but this provision and the related provisions often prove to be a tax quagmire for many practitioners.

The shares must meet three tests to be considered QSBC shares and become eligible for the CGE.

Small Business Corporation Test

At the time you sell your shares, they must be shares of a Small Business Corporation (“SBC”). A SBC, amongst other criteria, must be a Canadian-controlled private corporation whereby all or substantially all (meaning 90% or greater) of the fair market value (“FMV”) of the assets of which at that time is attributable to assets that are used principally in an active business carried on primarily in Canada.

In plain English: at the time of the sale, the company must be using a minimum of 90% of its assets in carrying on an active business in Canada. In other words, if you have more than 10% of the FMV of your corporation in passive assets such as cash, stocks, rental real estate, you may be offside the rule.

It is important to note that the Goodwill (which is often the largest asset) of a business will count as an asset used in an active business. However, generally cash, portfolio investments and intercompany loans will not qualify as active assets.

Holding Period Ownership Test

This test requires that the shares cannot have been owned by anyone other than the individual or a person or partnership related to the individual, throughout the 24 months immediately preceding the disposition time. The two year test is very confusing. It is a rule that at its core is intended to prevent anyone not related to you from holding the shares within the last two years. However, on one hand the 24 month rule provides for exceptions such as if you transfer a proprietorship or partnership to a corporation, yet if you incorporate a new company and hold the shares less than 24 months, you will be disqualified.

In plain English: in most cases you will be required to have held the shares two years prior to the sale.

Holding Period Asset Test

If you thought the above rules were complicated, this test makes the other rules seem simple.

This test requires that throughout the 24 months immediately preceding the sale, more than 50% of the FMV of the corporation's assets must have been attributable to assets used in an active business. For this purpose, assets considered to be used in an active business consist of:

1) Assets used principally in an active business carried on primarily in Canada by the corporation or a related corporation;

2) Certain shares or debt of connected corporations; and

3) A combination of active business assets or certain shares or debt of connected corporations

In plain English: at least 50% of the company’s assets must have been used in an active business throughout the two-year period prior to sale.

Where you have a holding company ("Holdco") or stacked companies (Holdcos owning Holdcos) ultimately owning the shares of an operating company, the threshold percentage for meeting the Holding Period Asset Test may become 90% instead of 50%. These rules are far too complicated to discuss, suffice to say, if you have a chain of companies, at least one of the companies in the chain must meet the 90% threshold percentage over the two-year period.

As you can see, the CGE is no gimme. You need to ensure you hold the shares 24 months, at the time of sale 90% of the assets are used in an active business and over the prior 24 months, 50% (in some case 90%) of the FMV of the assets were used in an active business.

Traps and Obstacles

Holding Companies

Many small business owners utilize a Holdco for creditor proofing, which is often recommended. However, over years the Holdco may end up owning substantial investment assets. These assets may be problematic for the following reasons:

1. Since Holdco owns your operating company ("Opco"), you have to sell your holding company shares to a buyer to qualify for the CGE and if you have substantial assets, you need to remove them prior to a sale. This may trigger a substantial tax liability and/or cause the shares to fall offside the QSBC rules.

2. Many people use their Holdco to hold the shares of other corporations. This is very problematic when you want to sell your shares of Company A, but your Holdco not only owns Company A, but also owns shares of Company B and Company C. How do you get the shares of Company B and C out of your Holdco prior to the sale? The answer is - not easily.

As I have written in prior blogs, I often suggest rather than automatically interposing a Holdco between you and your Opco, you may wish to consider using a family trust with a corporate beneficiary (a Holdco typically owned by you). Thus, instead of the cash being plugged up in your Holdco and potentially putting you offside the QSBC rules, your Opco pays a dividend of the excess cash to your family trust which in turn allocates a tax-free dividend (in most cases) to the holding company beneficiary of the family trust.

This is a very subtle point, but now instead of having the dual problem of your Holdco company potentially having too many investment assets and/or you needing to sell your Holdco shares to access the capital gains exemption, you can now just sell the Opco shares, as the operating company is owned by the trust. The Holdco company even if it has accumulated substantial assets, is not part of the three CGE tests as it has no direct interest in the company being sold.

Safe Income

I have no desire to get into this complicated issue. However, where a Holdco or Opco has other assets such as excess cash, shares in other corporations or real estate that a purchaser does not require, it is often necessary to transfer these assets out of Opco or Holdco (known as purification). This is often done by cross share redemptions that result in dividends. All you need to know for purposes of this post is that if an operating company pays a dividend to another corporation in contemplation of a sale and the dividend exceeds the recipient’s proportionate share of safe income (in very simple terms, retained earnings of the dividend payer) the excess portion becomes a taxable capital gain. This can be very problematic when you are trying to purify your corporation of excess assets prior to the sale to qualify for the CGE and you definitely require your tax advisor's assistance.

Cumulative Net Investment Loss

The Cumulative Net Investment Loss (“CNIL”) account tracks an individual’s net historical investment income. Essentially it is the sum of your investment income, such as interest and dividends, less investment expenses such as interest expense, carrying charges, losses from limited partnerships and resource deductions from flow-through shares. If the cumulative balance is negative, this balance restricts access to the CGE. The negative balance can in many circumstances be eliminated by having your company pay you a dividend prior to any sale, subject to the safe income rules noted above.

Allowable Business Investment Losses

An Allowable Business Investment Loss (“ABIL”) typically results from capital losses on shares and debt in private Canadian corporations. If an individual has realized an ABIL in a prior year, it will reduce his or her CGE available to claim. Thus, you need to confirm if you have ever made such a claim prior to utilizing your CGE.

Insufficient Dividends

This issue is way beyond the scope of this article, however, where it is reasonable to conclude that a significant portion of the gain is attributable to the fact that a minimum amount of dividends has not been paid annually on any class of shares in the corporation, other than classes of "prescribed shares”, the CGE can also be restricted. Ask your accountant if this is an issue for you.

Planning

Prudent planning would suggest that you and your advisor consider these rules far in advance of any potential sale, so you can monitor whether your corporation is onside the rules. Where the corporation falls offside you can “purify” the corporation of any offending assets. Purification should be ongoing, because if you have to purify at the last minute, there is a good chance you will not meet the various criteria to qualify for the exemption.

If you are still with me, I am sure you will agree that you should never assume your corporation’s shares will qualify for the CGE. The morass of rules requires you and your advisors to carefully navigate the rules to ensure your shares will qualify when you decide to sell your corporation.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Business and Income Tax Issues in Selling a Corporation

The sale of your business/corporation is typically a once in a lifetime event. Thus, in most cases, you will never have experienced the anxiety, manic ups and downs, legal and income tax issues, negotiating stances, walk-away threats and all the other fun that comes with the experience.

In order to navigate the sale minefield and to come up with a fair negotiated deal, you will require a team that includes a strong lawyer(s), accountant and maybe even a mergers and acquisitions consultant. 

With all that to look forward to, I figured I would provide some of the meat and potato issues you will also have to solve and negotiate.

Assets vs. Shares

In general, the sale of shares will yield a better return for the seller than the sale of assets, especially if the vendor(s) have their $750,000 Qualifying Small Business Corporation (“QSBC”) capital gains exemptions available. However, the purchaser in most cases will prefer to purchase the assets and goodwill of a business for the following two reasons: (1) The purchaser can depreciate assets and amortize goodwill for income tax purposes, whereas the cost of a share purchase is allocated to the cost base of the shares (2) the purchaser does not assume any legal liability of the vendor when they purchase assets and goodwill; whereas under a share purchase agreement, the purchaser becomes liable for any past sins of the acquired corporation (of course, the purchaser’s lawyer will covenant away most of these issues as best they can).

Consequently, the purchaser typically wishes to buy assets whereas the seller wishes to sell shares and thus, the first negotiation point. Whichever way it goes, the buyer knows why you want to sell shares and will typically discount the offer when buying shares instead of assets.

Working Capital (“WC”)

WC is the difference between current assets and current liabilities and measures the liquidity of a company. In simple terms, working capital is cash plus accounts receivable and inventory less accounts payable. WC can be a huge bone of contention in any sale, but especially in an asset sale. The purchaser in most cases blissfully assumes they will keep all the WC and also get a multiple of the corporation's earnings as the sale price. The purchaser typically wants enough WC left in the business such that they will not need to finance the business once they have made the initial purchase and contributed whatever cash or line of credit they feel is required upon the initial purchase.

The WC is a very esoteric concept at best and very hard for most sellers to grasp. Thus, it is vital to deal with this issue upfront and not leave it to the end where it can derail a deal, something I have experienced first-hand.

Valuation

Most sellers have valuation multiples dancing around in their heads like little sugar plum fairies. However, most industries have standard valuation multiples. For most small businesses the multiple is somewhere between 2 and 4 times earnings, with a higher multiple for strategic acquisitions, especially where the purchaser is a public company, since they themselves may have a 15 to 20 multiple.

For many acquisitions, especially by public and larger corporations, the multiple is based on Earnings before Interest, Taxes and Amortization (“EBITA”). However, in addition to EBITA, there will be adjustments to the upside for management salaries in excess of the salary that would be required to replace the current owner (typically you are adding back bonuses paid to the seller in excess of their monthly wages and any other family wages). Occasionally the adjustment could be to the downside, but that is typically only in situations where the business is a technology company or similar that is just starting to make money or finalize a desired product, and the owners wages have not yet caught up to market value. Finally, there will be other additions to EBITA for things like car expenses, advertising and promotion, etc. that a new owner would not necessarily need to incur upon the sale.

Where a purchase is made by a private company, instead of EBITA, the price may be based on a capitalization of normalized after-tax earnings or discretionary cash flows.

Retention

In most cases, the purchaser will require the seller to stay on for a year or two to ensure a smooth transition. The owner will thus be entitled to a salary for that period in addition to the sales proceeds. The retention period can go several ways, some blow up quickly, some end after the year or two, but often the former owner stays on as the business is now growing due to additional funds or more sophisticated management and they enjoy remaining with their baby without the stress of ownership.

Continued Ownership

It is not uncommon for a purchaser to require that the seller maintain some ownership in their company so that they still have some “skin” in the game, especially when they will be staying on with the business. This is also the case where the purchaser is consolidating several similar businesses with the intent of going public. In these cases, we counsel our clients to assume the worst (i.e. that the new owner will make a mess of the business) and to ensure they receive proceeds equal to or only slightly less than they initially desired. We have seen several disasters in consolidation purchases where the seller ends up with minimal proceeds after keeping significant share positions with the lure of the consolidated entity going public and the consolidated company just does not have the expected synergies.

Tax Reorganizations

Where the deal is a share purchase, often the current corporate structure is not conducive to utilizing the QSBC capital gains exemption, especially where a holding company is in place or the company being sold has a large cash position. It is thus vital to ensure at least some initial income tax planning is done so that if the deal moves forward, proper consideration has been given to the income tax planning and the planning is not a wild last minute scramble.

I have only touched on a few of the multitude of issues you encounter upon the sale of your business. As noted initially, it is vital to understand the process and how stressful it may be from the start, and to assemble the proper team to help you navigate through the sale process.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.