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A business owner, when contemplating selling the business, must consider several factors, including financing, when determining how to structure a sale. It is very important that the owner have all the necessary information to ensure the most effective and efficient decision is made. Obtaining the necessary information not only involves the business owner, but also involves his or her advisors, which may include lawyers, accountants, and bankers.
When the seller is helping the purchaser with the sale by taking back vendor financing, it is very important that the cash flow and tax consequences involved in the sale be considered. Otherwise the seller could end up in a very precarious situation.
One example involved a couple in their 60s who lived in B.C. and operated a very successful business. The couple operated and owned the business through their holding company. The only asset the holding company owned were the shares of the operating company. The shares of the operating company had a nominal adjusted cost base of $1 and had a fair market value of $1,400,000. The couple, with the advice of their lawyer, had agreed to sell the business to an employee and help finance the purchase. The sale was structured as a share sale by the holding company of its shares of the operating company to the key employee for $1,400,000. The terms of the sale were such that the holding company would receive $100,000 on signing of the agreement with the purchaser making interest only payments at 4.5% for the first five years. The agreement also allowed the purchaser to have an option to renew the agreement for interest only payments for another five year period. Therefore, the holding company received $100,000 and approximately $58,500 a year in interest income (which it would have to report on its tax return) over a ten year period.
Under the Income Tax Act, a seller is entitled to defer a portion of the capital gain (called a capital gain reserve) to future years where the proceeds from the sale of a capital property are not received until after the year end. This capital gains reserve is calculated based on a formula and one of the factors is the amount of proceeds received. However, at a minimum, at least 20% of the capital gain must be reported each year over a five year period. In our situation, the holding company, as it is selling a capital property and not receiving the entire proceeds immediately, would be entitled to claim this reserve. The result is that the holding company would have to report a capital gain in its tax return for each of the next five years. The tax liability would be approximately $62,500 a year. In addition, the holding company would be subject to income tax of $26,000 every year on the interest it earns from the promissory note. This would result in the holding company having an annual tax liability of approximately $88,500 a year in each of the next five years ($62,500 tax on the capital gain and $26,000 tax on the interest income).
The problem was that the tax liability over the five year period would have been $442,500, but the holding company would only be receiving approximately $392,500 in cash ($100,000 initial payment plus $58,500 in interest for five years). The holding company would face a cash deficiency of $50,000. When the couple had negotiated the sale agreement, they together with their advisors, had failed to consider the tax consequences and resulting cash flow problem when agreeing to the deal.
The couple approached MNP to ask for help in trying to solve their cash flow problem. Prior to the deal closing, MNP analyzed the sale agreement and we were able to renegotiate the deal by having the couple sell their shares of the holding company instead of the holding company selling the shares of the operating company. This change, not only solved their cash flow problem, it allowed the couple to utilize their capital gains exemption and avoid paying any income tax on the sale of their shares of the holding company. This resulted in a tax savings of over $300,000 to the couple.
The couple incurred some additional legal and accounting fees to renegotiate the sale agreement, which could have been avoided if they had obtained the proper information before agreeing to sell the business. Therefore it is important when making a decision to sell a business, finance the sale, or any major decision that you have all the information necessary to make best decision for you and the company.
Related Topics:Selling a Business
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