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All too often, I run across transactions that have been undertaken at less than fair market value. This may seem like a benign event and a good planning option either to minimize tax on the sale or to help the purchaser pay less than fair market value. However, in a non-farming situation, there are tax consequences that surprise many clients and their advisors.
Consider this typical situation: A child is active in the business operations with a parent, and the parent sees this child as the natural successor of the company. The parent decides to sell a portion of the company’s shares to the child for $1, as the parent does not want to pay tax and the child cannot afford to pay for the shares. At the time of this transfer, the shares to be sold are actually worth $100,000.
The tax consequences in this scenario may be surprising. The parent will be deemed to have proceeds equal to the fair market value of $100,000, regardless of the actual price paid, and the child will only get credit for $1 for the new cost. If the parent had a nominal cost, the parent would have taxes payable of almost $20,000, in Alberta.
Let’s further assume the child eventually sells the shares a few years later, when their value has risen to $200,000. The child will have a capital gain as the difference between the proceeds of $200,000 and the $1 purchase price. There will be almost $40,000 of taxes owing, in Alberta. Essentially, both the parent and the child have paid tax on the difference between $1 and the $100,000, with a consequence of double tax.
What could have been done differently? The easiest scenario would be for the parent to gift the shares to the child for no proceeds. For tax purposes, when a gift is made, both the vendor and the purchaser have correlating tax results – the proceeds to the vendor will be the same value as the cost to the recipient.
Using my same scenario, the parent would owe tax at the time of the gift of approximately $20,000, just like the sale at $1, but the child would have a new cost of $100,000 even though this was a gift. Therefore, when the child eventually sells the shares, only the increase in value will be taxable as a capital gain. The child would owe taxes of only $20,000 when the shares are sold, rather than $40,000 owing if the child had acquired the shares for $1.
It’s important to remember these rules apply regardless of whether the vendor and purchaser are related to one another. It may even be possible for the vendor to use their capital gain deduction on the gift, provided the shares qualify for the capital gain deduction.
The price of transactions at $1 is very costly to the recipient and the vendor is usually indifferent. In order for the transaction to be treated as gift for tax purposes, the documents must support that. It is important that your legal counsel and accountant are aware of these differences and that documentation is prepared appropriately.
Don’t hesitate to contact me or your local MNP tax advisor for assistance in implementing your sale transactions.
Related Topics:Family; Capital Gains; Personal Tax
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