Before You Sell – Restructure Your Business for Tax Efficiency
Your company’s corporate structure may be the same as the day you opened your doors or it may have evolved over time. Either way, while your current structure may have made sense in the past, it may not be ideal for the purpose of selling your business. The following is a brief look at some options you can consider to help minimize your tax bill when you sell. Keep in mind that corporate restructuring takes time so planning ahead is essential.
You can choose to structure the sale of your business as an ”Asset Sale” or a ‘”Share Sale”. Tax considerations are certainly not the only issue at play in deciding which route to take, but it is a significant factor as both offer options for minimizing tax. Generally, the seller would prefer to sell shares, while the purchaser would prefer to buy assets. For the seller, a share sale will likely cost less in tax. For the purchaser, an asset transaction will allow for a higher cost base on which to claim asset depreciation. The purchaser can also recognize and depreciate any goodwill associated with the business in the case of an asset sale. Both of these are tax-advantageous to a buyer. However, an asset sale may be subject to sales tax, HST and land transfer tax, which would be paid by the purchaser. An asset purchase can also be more complex to implement, because each asset must be transferred and registered in the name of the purchaser.
Minimizing Tax on a Share Sale
There are several methods that a seller can use to defer or minimize taxes in the case of a share sale. For example:
- There is an enhanced lifetime capital gains exemption of $800,000 (subject to yearly inflation) that can come into play in the sale of shares of a qualified small business corporation. It’s only available to people who are resident in Canada throughout the year, and there are a number of ”tests” to determine if you qualify for the enhanced capital gains exemption.
- You might also consider making family members shareholders in your corporation. They may then be able to use their own lifetime capital gains exemption when their shares in the company are sold.
- Another method is to remove value from your business prior to the sale. Although you would still pay tax on this removal, it may be less than the cost of a capital gain. Examples of this strategy are shareholder loans to the business, which can be repaid without tax; distributing the balance of the Capital Dividend Account to shareholders; and ”Safe Income”, which can be extracted and passed onto another cooperate entity.
- A retiring allowance is defined as “an amount received at retirement in recognition of long-term service or as compensation for loss of employment.” If your business is incorporated, you can pay yourself a retiring allowance. The advantage is that you can transfer some of it to an RRSP without affecting your deduction limit and without being taxed immediately. If your business is not incorporated, you can still pay a retiring allowance to your employees, including family members.
- A capital gains rollover can be used to invest the proceeds of the sale of your shares in your business into another active Canadian corporation. This is a tax-free option available under the Canadian income tax rules.
- Payment of the purchase price can be deferred by including an earn-out provision in situations where a buyer and seller have different opinions on the valuation of the company. The earn-out helps bridge this gap, as a portion of the purchase price is based on the company’s future results and paid a designated period of time after the sale closes.
For tax purposes, an earn-out payment can be characterized as payment of deferred contingent purchase price, payment of ordinary compensation
for your continued services (if you have agreed to an earn-out, you will retain some control and responsibility in the company, so you can affect the results on which the earn-out is based), or part compensation and part purchase price. Income treated as compensation will be taxed as ordinary income, while income treated as deferred contingent purchase price will be taxed at the lower capital gains rate. A portion of the earn- out payment will likely be deemed compensation if you provide continuing services or enter into an employment agreement or a non-compete agreement with the buyer.
Minimizing tax on an Asset Sale
There are fewer methods to reduce tax in an asset sale, but they are certainly worth noting. For example:
- Allocation of purchase price – The value of different assets is a key factor in determining tax costs. The purchaser of your business will want to see different assets valued in the most advantageous way possible. Land for example, does not depreciate over time, while equipment and buildings do. The purchaser would wish to minimize the cost allocated to the land, and maximize that for equipment. This may be very different from what will benefit you, the seller, so it is a key part of the sale negotiation.
- Defer payment of the purchase price – You can choose the same route as outlined above as part of an asset sale.
Kelly Santini LLP will work with you and your tax advisors to find out whether your corporate structure would be tax effective in the event of a sale. If a deal becomes imminent, your window to restructure may have closed as there are complex rules regarding “holding periods”. Your corporate planning must be done in anticipation of a future sale, rather than as a reaction to an offer or change in your industry. The benefits of reviewing your corporate structure can be reaped immediately, for example, keeping your company’s tax bill at the lowest possible rate, limiting legal liability, and distributing excess cash in a tax efficient manner (for example, by taking advantage of “income splitting” opportunities).
To learn more about selling a business, download a copy of ‘Preparing Your Business for Sale‘ guide.