Tax-Efficient Exit Strategies for Businesses
Murray Shapiro for The Lawyers Weekly
One in four owners over the age of 50 of small and medium-sized businesses plans to exit their business within the next five years, according to an study
by the Royal Bank of Canada. However, 77 percent of owners have made little or no progress putting a plan in place. The opportunity is clear - those who plan ahead have more options, better tax efficiencies and more positive outcomes.
Let's start with those who do not plan ahead. An owner may receive an unsolicited offer to buy the business, and be forced to make a quick decision if the price is right. He may not have been thinking of selling, now or ever, but might also never see this number again.
If he sells, how much of the funds received will he be able to keep? Without any planning, in Ontario, with capital gains tax rates at effectively 23 percent, he will keep 77 percent of the proceeds beyond his investment. So if the business sells for $5 million and the owner's investment is nil, he will end up with $3,840,000 after tax.
What strategies might this owner employ to reduce his tax hit? First, if the buyer is willing to buy shares rather than assets, then the business owner, and any other owners of shares of the business, can make use of their one-time $750,000 capital gains exemption.
However, with no pre-planning, it is entirely possible that the shares of the company will not qualify, as they would have to be held for at least two years and pass both the "active Canadian business assets" tests. These tests are met if at least 90 percent of the assets are used in an active business in Canada at the time of sale, and at least 50 percent have been so used during the past 24 months.
If the business is not already incorporated, this can be done just before the sale to take advantage of the capital gains exemption, which means the two-year holding period is not applicable.
The net tax saving from using the capital gains exemption in Ontario is $174,000 for each person.
Another strategy that can be employed without pre-planning is to make a charitable gift either to a registered charity or to one's own charitable foundation in the year of the sale. The business owner's tax burden will be reduced by the amount of the donation tax credits, effectively 46 percent of the amount donated.
If the business owner invests in another Canadian business in the year of the sale or within 120 days after the year of sale, then some or possibly all of the capital gain may be deferred until the sale of the new business.
Finally, a strategy called a "safe income strip" can potentially convert part of the capital gain on a sale into a dividend that will be taxed only on distribution to the business owner. This distribution can be deferred - potentially until the death of the business owner, and life insurance can be used to reduce or fund taxes at death.
For those who do plan ahead, there are a number of benefits. For example, they can ensure that the shares of the business qualify for the capital gains exemption.
Perhaps the best tax savings strategy for a business that is expected to grow in value over time is an estate freeze. An estate freeze allows the business owner to share the growth of his business with others, usually family members. This allows for multiple use of the capital gains exemption and splitting income generated by the business with family members, within the framework of the income tax attribution rules.
The business owner could also set up an individual pension plan prior to the sale, which results in tax deductions for the corporation, tax-free growth for the assets in the plan and a lower capital gain on a sale.
If the business owner dies unexpectedly, the ability to plan ahead to reduce and fund the tax payable upon a deemed disposition of his interest in the business is seriously minimized, and his family may even be forced to sell the business.
With an estate freeze in place, a significant part of an otherwise deemed disposition of the full value of the business can likely be deferred until a suitable time, such as a planned sale. This avoids forcing the business owner's family to address his tax liability on the full appreciation of the business at the time of his death.
Business owners who plan ahead with a team that includes legal and tax professionals and an investment advisor can employ numerous sophisticated tax strategies to achieve their personal objectives and maximize their wealth.
Murray Shapiro is Vice President, High Net Worth Planning Services with RBC Wealth Management Services.