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A financial planner contact recently brought a new client to me. The client (“Bob”) was investigating incorporating his business and wanted to understand the benefits. Bob had built his business over the last 8 years and was looking at selling within the next 5 years. He already had potential purchasers asking: “would you consider selling?”
Most business owners are aware of many of the benefits of incorporating their business. For example, corporations can offer lower corporate income tax rates on active business income, larger after-tax earnings available to pay off corporate debt, limited liability protection for the shareholders, etc. But one of the biggest advantages to the small business owner can be the future use of their capital gains exemption on a sale of shares of a qualifying small business corporation. Every individual can shelter up to $750,000 of capital gains on qualifying dispositions. In other words, $750,000 can be received essentially free of regular income tax. In Saskatchewan, this is a savings of up to $150,000.
Previous blogs have discussed the rules for claiming your capital gains exemption (for example, see the February 17, 2011 blog post by Kim Drever), so I will be brief here. In general, during the 24 months prior to the sale, the shares must have been held by the taxpayer and more than 50% of the fair market value of the assets of the corporation must have been used in an active business carried on in Canada. At the time of the sale, more than 90% of the fair market value of the assets of the corporation must be used in an active business carried on in Canada.
It was this 2-year hold test that had my new client and his financial planner concerned. What would happen if Bob received “an offer he couldn’t pass up” and he had only been incorporated for 6 months?
A little known exception exists in the Income Tax Act , which addresses this exact situation.
If the incorporation and business transfer transactions are structured properly and the operations being transferred constitute “all or substantially all the assets used in an active business carried on by that person”, then the Act allows my sole proprietor business operator, Bob, to incorporate his business one day, sell his shares the next day and access his capital gains exemption on the sale. The phrase “all or substantially all” is interpreted by Canada Revenue Agency to mean 90% or more. Care must be taken to ensure the provisions in the Act are strictly followed to allow the taxpayer access to his or her capital gains exemption. This exception also applies where the business has been carried on in a partnership. Be sure to investigate the Excise Tax and Provincial Sales Tax implications as well.
To learn more about incorporating your business, contact your local MNP tax specialist.
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