What is the Lifetime Capital Gains Exemption?
Imagine for a moment that you are the owner of a business. Since you founded it or since you bought it, you have been successful and the business has grown, and now you are looking to sell.
Easy to imagine? Are you in this position?
When you sell an asset that has increased in value (such as a house, stocks, or, in this case, a company) CRA wants their cut and will tax you on how much that asset’s value has increased. The increase in value is known as the ‘capital gain’. Fortunately, however, the Canadian Income Tax Act has a unique provision known as the ‘Lifetime Capital Gains Exemption’, or LCGE. In 2021, the LCGE allows you to exclude up to $892,218 of capital gains earned on the sale of a qualifying business, or up to $1,000,000 on the sale of qualifying farm or fishing property, from your taxable income. The limit on the exempt portion from the sale of a qualifying business is indexed to inflation.
This limit is a lifetime amount, so there’s no double-dipping. For example, if you sell your business, recognize a capital gain of $500,000, and claim the full amount under the LCGE, then you have $392,218 remaining should you sell another business in the future.
What is a Qualifying Business?
Perhaps unsurprisingly, there are restrictions on what businesses qualify for the LCGE.
First and foremost, to be eligible, you must sell ‘qualifying small business corporation’ (QSBC) shares. This has a few implications – the business must be incorporated, and you have to sell shares of the company rather than the company’s assets. It must also be a private company (publically traded companies don’t count).
To be classified as a QSBC, your (incorporated) company has to meet three tests:
- At the time the corporation is sold, 90% or more of the assets have to be in Canada, and have to be used actively in the business. Assets not being used actively could include an investment portfolio, excess cash, or a rental property.
- For the two years leading up to the sale, 50% or more of the assets have to continuously be in Canada, and have to be used continuously and actively in the business.
- The shares of the business must be owned by you (or someone related to you) for the two years leading up to the sale.
There is one other restriction – the LCGE is only available to individuals who are residents in Canada.
What if the Company Doesn’t Meet the QSBC active asset tests?
This is a fairly common problem – especially the first criteria of having more than 90% of assets being considered active and in Canada.
To rectify the issue, you have two choices. Either reduce the assets considered ‘passive’, or increase those considered ‘active’. For example, you could pay excess cash out of the business as a dividend, or pay down any debts the corporation may have. Alternatively, you could purchase new assets to use in the business that would qualify as ‘active’.
Given how long the company needs to have 50% of its assets considered active, it is important to be proactive to ensure that these criteria are met.
What if I want to sell the Company to my Children?
There is sometimes a desire to see a family business stay in the family. However, the children may not always have the funds available to them to be able to buy the business to in turn allow the parent to claim the LCGE. Courtesy of new legislation released in 2021, there are now more opportunities to sell the business to the kids and use the company’s future profits to pay out the parents’ share in a tax-efficient manner.
Selling to your kids does come with a big caveat. To be able to claim the LCGE, you must completely exit the business. You can still give advice to your kids, but you can no longer own shares. This may not seem like a big deal – unless your payout is being financed by the company’s future profits.
If selling to the kids is still of interest to you, you should still proceed with caution – this legislation is likely going to be amended in the near future. For details, please refer to our article here.
If giving up control of the business (when your payout is still dependent on it being profitable) is outside your comfort zone, you have other options. For example, you may consider an ‘Estate Freeze’. In this scenario, you still get paid out from the company’s future profits, and the future growth of the business still gets attributed to your child, but you are able to retain control. The downside is that the LCGE is no longer available.
If you think the Lifetime Capital Gains Exemption (or an Estate Freeze) is something that would benefit you, talk to your McCay Duff advisor today. Our tax advisors provide expertise in all aspects of personal and corporate tax, ensuring compliance with the law while minimizing obligations. To learn more about how we can assist you, please contact us online, or by telephone at 613-236-2367, or toll-free at 1-800-267-6551.