Introduction
Canada’s tax system offers significant incentives for small business owners through the Lifetime Capital Gains Exemption (LCGE). This exemption provides substantial tax savings by reducing or eliminating the taxable portion of capital gains on the sale of Qualified Small Business Corporation (QSBC) shares.
As of 2023, the LCGE allows individuals to exempt up to $971,190 in capital gains from taxation. Given that only 50% of capital gains are taxable, this represents a potential tax saving of approximately $240,000 for individuals in the highest tax brackets. However, not all shares qualify as QSBC shares, and meeting the exemption criteria requires careful planning and adherence to specific requirements.
Definition of Qualified Small Business Corporation (QSBC) Shares
To qualify for the LCGE, the shares being sold must meet two key tests: the Asset Test and the Holding Test.
1. The Asset Test
This test evaluates whether the corporation meets the definition of a Small Business Corporation (SBC) under the Income Tax Act.
Requirements:
- Active Business Assets:
- At least 50% of the fair market value (FMV) of the corporation’s assets must be used principally in an active business carried on primarily in Canada during the 24 months before the sale.
- At the time of sale, at least 90% of the FMV of the corporation’s assets must be used principally in an active business. The CRA defines “substantially all” as 90% or more of the corporation’s assets.
- Connected Corporations:
- Shares or debts of connected corporations can count toward meeting the active business asset test if the connected corporation meets the same 50% and 90% thresholds. A corporation is "connected" if one corporation owns 10% or more of the voting shares and FMV of another corporation.
Challenges:
Passive investments, excess cash, or non-active assets can disqualify shares from meeting the QSBC definition. Purification techniques can help address this issue by transferring non-active assets to a related corporation tax-free, ensuring compliance with the active business requirements.
2. The Holding Test
This test ensures that the shares have been held for a sufficient period and by the appropriate individuals.
Requirements:
- Shares must be held by the individual or a related person for at least 24 months before the sale.
- During this period, no one other than the individual or related persons can own the shares.
This test prevents newly issued shares or recently acquired shares from qualifying for the LCGE immediately. Shares must be owned long enough to demonstrate a genuine connection to the corporation’s operations.
Benefits of the Lifetime Capital Gains Exemption
The LCGE provides small business owners and their families with significant tax planning opportunities:
1. Tax-Free Gains
Eligible individuals can sell QSBC shares and exempt up to $971,190 in capital gains from taxation. This exemption amount increases annually with inflation, enhancing long-term planning opportunities.
2. Family Capital Gains Splitting
The LCGE applies on a per individual basis. By transferring shares to family members or utilizing a family trust, multiple family members can claim the exemption, amplifying the overall tax savings.
3. Tax Deferral and Retirement Planning
Retaining QSBC shares until retirement allows small business owners to defer taxes on capital gains until the sale. By planning strategically, individuals can align the sale of shares with lower-income years to minimize tax liabilities further.
Challenges and Planning Strategies
Purification
For corporations with significant passive investments or non-active assets, purification is a critical strategy to meet the 90% active business asset test. This involves transferring non-active assets, such as excess cash or investments, to a connected corporation on a tax-deferred basis.
Family Trusts
Using a family trust can enable flexible distribution of the corporation’s value among family members, allowing for optimal use of each member’s LCGE. The trust structure also allows the primary shareholder to retain control of the corporation while planning for the future.
Timing of Transfers
Shares must be transferred to family members or a trust well in advance of a sale to ensure growth in value occurs while the transferee owns the shares. Late transfers could negate the tax benefits, as gains realized before the transfer remain attributable to the original owner.
Pro Tax Tips
- Plan Ahead: Start early to ensure the corporation meets QSBC criteria well before a planned sale. The 24-month holding period for the active business asset test cannot be bypassed.
- Optimize Family Exemptions: Use a family trust to distribute gains among family members strategically.
- Monitor Asset Mix: Regularly evaluate the corporation’s asset allocation to maintain compliance with the 90% active business requirement.
- Consult Professionals: Work with experienced tax advisors to navigate complex LCGE and QSBC rules, including purification and family trust strategies.
Conclusion
The Lifetime Capital Gains Exemption (LCGE) offers Canadian small business owners a powerful tool to minimize taxes on the sale of their business. However, meeting the Qualified Small Business Corporation (QSBC) criteria requires strategic planning and expert guidance.
For personalized advice on leveraging the LCGE or ensuring your corporation qualifies as a QSBC, consult our team of experienced tax professionals. With proactive planning, you can maximize your tax savings and achieve your financial goals.
This article is written for educational purposes.
Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at [email protected], or by visiting our website at www.taxpartners.ca.
Tax Partners has been operational since 1981 and is recognized as one of the leading tax and accounting firms in North America. Contact us today for a FREE initial consultation appointment.
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