Smooth transitions: Making the most tax-efficient exit through advanced business planning

Here, we follow the story of John, who built a successful manufacturing company over 20 years. With the wealth he created, he could give his wife, Carole, and their children a comfortable life. Carole had recently retired, and John was getting ready to sell the business so the couple could spend more summers at the lake.

John had a long relationship with MNP through his construction company. His business advisor referred him to Tao Ho and the firm’s tax team six years ago when they noticed potential tax efficiencies he might want to consider.

Grateful for the advice, John also saw an opportunity to begin a conversation he’d been pondering: The children had launched their careers, and he was sure that none of them were interested in taking over his company. Carole was eager for a change of pace. Though he wasn’t quite ready to exit the business, John wanted to start planning how that process would look.

John’s friend Stan had recently sold his own business. While he got a great price, his tax bill was shocking. When the time came, John wanted to be sure he would not be the victim of any similarly expensive surprises.

Failing to plan is planning to fail

“Most strategies for the sale of a business involve applying some foundational concepts of Canadian tax law,” says Tao. “But every business is unique, and so are the needs and goals of every business owner. A skilled tax advisor will consider all these factors to ensure the exit strategy is as tax and cost-efficient as possible.”

When selling a business in Canada, sellers may employ specific strategies to minimize overall taxes. These strategies require planning; their effects are not immediate. That's why failing to plan is planning to fail — a lesson Stan unfortunately learned the hard way.

“Planning for a business sale should involve a discussion regarding indirect taxes and income taxes. The transaction could be structured as a sale of business assets by the company or as a sale of company shares, and the overall tax implications are different for each,” says Tao.

Tao explained to John that either the company will dispose of the business assets or John will dispose of the shares of his company for tax purposes when he eventually decides to sell.

Tax authorities will generally calculate the capital gain by subtracting the adjusted cost base of the shares or assets from the sale proceeds. The adjusted cost base for a sale of shares generally includes the original cost of acquiring the shares. In John's case, like many business owners, this would likely be nominal because he started the business and grew it himself.

Several exemptions and structures — including the lifetime capital gains exemption (LCGE) and the ’24-month rule’ — can help to mitigate this tax liability. This is where John’s planning proved beneficial. Tao and the MNP team set up these structures to minimize the taxes that had eroded so much of Stan’s nest egg.

The lifetime capital gains exemption

Eligible individuals are entitled to the LCGE on the sale of qualifying small business corporation shares. In 2023, this amount is $971,190. Those who meet the eligibility criteria can shelter an amount up to the LCGE from capital gains tax, providing approximately $250,000 of tax savings per individual.

The '24-month rule’

To qualify for the LCGE, the shares being sold must meet certain criteria, including being held for more than 24 months preceding the sale. A crucial part of succession planning includes ensuring structures are in place for the owner to meet this requirement to utilize the exemption.

The family trust and restructuring

Tao recommended that John set up a family trust as part of his transition plan to hold the shares of the business.

John undertook a tax reorganization that allowed the trust to become a shareholder of the company and participate in the future growth of the business. Carole and the couple’s three kids became beneficiaries, eligible to receive distributions from the trust.

Subject to the tax on split income rules, this provided John and the family a future potential opportunity for income splitting among family members while the business kept operating — which helped to reduce the overall tax burden.

John will also be eligible to claim the LCGE when he decides to sell, a strategy that will help reduce the overall income tax owed when the transaction closes. In the event the shares held by the trust have accrued growth value and are sold, John may have an opportunity to further reduce the overall tax burden by distributing the proceeds from the trust to beneficiaries of the trust.

"By undertaking a tax reorganization and establishing a family trust, a business owner gains additional flexibility and tax planning alternatives,” says Tao. “More importantly, with a trust structure in place, the business owner would not need to give up any control of the business.”

While John has full control, he could provide the trust beneficiaries with the benefit of utilizing their LCGE or implement other tax efficiencies upon the eventual sale or transfer of the business. If the business does not sell during John’s lifetime, he would have the opportunity to defer potential future capital gains tax liability to the future generation on the growth value of the business accrued to the trust.

John was surprised by how simple and relatively straightforward it was to establish the family trust. He was also pleased to find out that through proper tax planning, his family can share in the proceeds of the eventual sale of his business in a tax-efficient manner — including the opportunity to shelter potential capital gains tax through their respective LCGEs.

He had been so worried about Stan’s unfortunate tax burden. As it turned out, that was entirely down to Stan waiting until the last minute to start planning for his exit.

Maximizing business value through compliance and strategy

The plan John and Tao settled on hinged on John selling shares of the company that operated the business so he and his family could benefit from the LCGE However, Tao explained to John that a sale of shares was not the only scenario he may want to consider — and that they would be wise to plan accordingly.

“Buyers have a wide range of acquisition needs and objectives. Instead of buying shares of the business, they may only want to purchase business assets, such as manufacturing equipment or real estate,” says Tao. “While that may negate the use of the LCGE, the right offer could be a worthwhile trade-off provided the right restructuring plans are in place to address any challenges that arise.”

The forward-thinking measures John took six years ago and the steps he is taking now with his MNP advisors have ensured he understands the range of options available to him and their various implications. His decision to reach out for professional support well in advance helps to ensure that every aspect of the business will stand up to even the heaviest scrutiny when he decides to sell.

“When potential buyers conduct due diligence, they meticulously examine the business's financial and compliance records,” says Tao. “There is considerable value in having a qualified third party provide assurance of the business’s accounting and governance beforehand as this avoids any unwanted surprises and can significantly elevate the business’s overall value.”

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