Passing Along the Business
When you pass along a business to the next generation there are significant tax implications to consider.
For many business owners, the natural plan for their corporation’s succession is to transfer ownership to the next generation. While there are many factors to consider when deciding to keep the business in the family, the tax implications can be significant.
TO GIFT OR NOT TO GIFT?
There are two general ways that an owner can transfer their business’s shares to the next generation: gift the shares or sell the shares. Both are treated exactly the same for tax purposes, but their tax outcomes can differ. A gift of shares doesn’t require the next generation to pay any funds to acquire the shares. For tax purposes, the person making the gift is deemed to have sold their shares at fair market value (“FMV”). If the FMV of the shares exceeds its adjusted cost base (“ACB”), there will be a taxable capital gain. The resulting tax liability can potentially be reduced if the transferor has not previously used all, or a portion, of their lifetime capital gains exemption (or LCGE, which is $848,252 for the 2018 tax year).
A sale of shares has certain tax nuances to consider. Regardless of the sale price negotiated, the transaction is considered to take place for tax purposes at FMV. So, providing a “family discount” will not reduce the income tax liability. In fact, it has an even worse implication: double tax.
While the tax authorities will adjust the proceeds received on the sale for tax purposes to FMV, the purchaser’s cost base is still the purchase price negotiated. This means that the difference between the FMV and the actual purchase price will be taxed at the time of the sale and again when the next generation sells the shares. The LCGE could potentially be used to reduce the gain. In addition, if debt is taken back as part of the sale of the shares to your child, the capital gain could potentially be deferred over a period of up to 10 years.
One of the challenges sometimes faced by owners in either case is determining the FMV of the business when shares are gifted or sold. In cases where a significant capital gain exists, the taxes due may not have been anticipated. A valuation of your business performed by a professional should be considered.
An estate freeze is a transaction that can effectively be viewed as a way to both gift and sell the company to the next generation. This allows the seller to estimate and cap their potential death tax liability today and develop an estate plan that includes the payment of the income taxes. In general, an estate freeze involves the exchange of the existing common shares in the business for fixed-value special shares (similar to preferred shares) that are worth the FMV of the company. New common shares of the company are then issued to the next generation for a nominal amount (i.e., the “gift”). Any future growth in the value of the business is attributed to these shares.
At the same time, the owner can redeem the special shares on an annual basis using the company’s current and/or retained earnings (i.e., the “sale”). However, the redemption of shares would be taxed at dividend tax rates and not capital gains tax rates, thereby making it a potentially more costly transaction from a tax perspective for the transferor.
As always, every situation differs so the advice of an accountant familiar with business succession planning can be valuable when it comes to understanding the tax implications.
If you need assistance please contact your Wealth & Estate Planning Specialist.
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