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Oct 2, 2017

Capital Gains Exemption Explained Is It Really As Good As I Hear?

by Tim Adams

Tim AdamsAs an accountant advising small business owners, one of the most common questions I am asked is: “If I sell my business, is it tax-free?” Most business owners have heard of the lifetime capital gains exemption. However, the ins and outs of how it works are more complicated than they initially sound. Nonetheless, with proper planning, the use of the exemption can save a significant amount of money.

What Is The Capital Gains Exemption?

For shares of a small business corporation to qualify for the exemption, they must meet the definition of “qualified small business corporation shares”.

The owner, or a person related to the owner, must have owned the shares for a two year period prior to the sale.

The company must be Canadian controlled.

At least 90% of the corporation’s assets at the time of sale and 50% of its assets during the two years prior to the sale, must be used in an active business in Canada.

If the company has assets that are not being used in the active business, you may need to take steps to “purify” the company to meet the tests noted above. It should be common practice in any small business setting to ensure that the 50% test is constantly met and that the 90% test can be met fairly quickly if needed.

The capital gains exemption was set at $800,000 in 2014 and indexed each year after that. The limit for 2017 is $835,714.

Recently Proposed Tax Changes

Prior to the proposed tax changes announced in July of this year, it was common practice to multiply access to the capital gains exemption with the use of a family trust. The family trust would allow each beneficiary of the trust to use their capital gains exemption. The structure would have the main business owner, in addition to their spouse and any children, claim the capital gains exemption.

The proposed rules incorporate the following changes:

i)         individuals under 18 can no longer claim the capital gains exemption.

ii)        the capital gains exemption cannot be claimed by individuals who are not active in the business (special rules surrounding “split” income would govern this restriction).

iii)       capital gains accrued under a trust would not be eligible for the capital gains exemption.

The proposed rules would apply to dispositions after 2017. Transitional rules allow individuals to elect to realize a gain on the shares owned by a trust in 2018. Also, the 50% rule mentioned above would only be applicable for the prior 12 months versus the usual prior 24 months.

If your small business is currently owned by a family trust, it is strongly recommended that you put a plan in place to utilize any capital gains room that may be available now, but might not be after 2018. A process known as “crystallizing” the gain could be used to claim the exemption. This would permanently increase the adjusted cost base of the shares.

Restrictions

The capital gains exemption can be reduced through a few specific tax items, including prior claimed business losses and cumulative net investment losses. Due to the complexity of the rules, seek professional tax advice prior to claiming any exemptions.

Proper use of the lifetime capital gains exemption on qualified small business corporation shares can result in tax savings in excess of $200,000. Accordingly, take care to ensure that your business is properly structured to meet the criteria as outlined above.

                                                                

Tim Adams, CPA, CA, partner at MAC LLP, Waterloo. He can be reached at tadams@mac-ca.com. For additional information visit www.mac-ca.com.