Business owners are committed to their businesses. They’re an integral part of our lives. While careers and work are also important to employees or professionals, it’s not the same as the relationship between business owners and their businesses.
While businesses are not living beings, like our children and spouses, they mean almost as much to the owner. We (including myself) think about our businesses all the time. I don’t know a business owner who has not lost sleep over their endeavour.
Some of us can bring our children, spouses and close relatives into the business. They may even take over and continue your legacy. What better gift can one give your loved ones than your cherished business that will hopefully provide for successive generations of your family.
Businesses are worth money. While you may simply wish to give your business to your child or children, Canada Revenue Agency (CRA) still wants a piece of the pie. That’s because the Income Tax Act of Canada stipulates when a person (or corporation) transfers the business to another party, they do so at fair market value and are taxed accordingly. Essentially, CRA doesn't care about the price at which you transferred the business (even if you did so at $1). It cares that you pay the tax based on the Fair Market Value. This means if you give your business to your children, you will pay the tax owing to CRA based on the sale at a much higher price. So, you “lose” twice. You lose because you don’t get any consideration (money) for the value of your business, and you must pay taxes on the “sale”.
There’s one exception. If you transfer your business to your spouse, you can do that on a tax-deferred basis. It simply means the taxes owing on the disposition (“sale”) of the business will be payable once your spouse sells it. You don’t avoid taxes, you simply push them back, like one does when investing in the Registered Retirement Saving Plan (RRSP). You pay the tax when you withdraw from your RRSP (or Registered Retirement Income Fund). Similarly, your spouse or you pay the taxes when they sell it.
Firstly, you can sell outright, whether it be to your children or an unrelated third party. In this case, you can sell the assets or the shares of your company. If you sell the shares, you may be eligible for the Capital Gains exemption, resulting in significant savings. Either way, you get the full value of your business. We like this because it’s clean and quick (relatively speaking).
Selling outright to your children can be problematic. Your children will need capital to buy. If they don’t have the full purchase price (which most young adults don’t), they’ll need to borrow. Most banks require 25 per cent down when buying a business. They must also qualify with the bank. Banks are in the risk mitigation business, so they examine borrowers closely and seek a lot of collateral.
If your children don’t have access to funds to buy you outright, you can opt for the freeze. Under this strategy, you “freeze” the value of your estate. But to do that, you must be incorporated. If you’re not, you can probably incorporate first and then proceed with the freeze.
Conceptually, the freeze crystalizes the value of your corporation in preference shares. For example, if the corporation issues 100 common shares and your corporation is worth $7 million, then each share is worth $70,000 ($70,000 x 100 shares = $7, 000, 000). In a freeze, you would exchange your 100 common shares for seven million preference shares worth $1 each. Those shares will not change value. They’re “frozen” at $1.
Once you exchange all of your common shares, all the value of the corporation is vested in the new preference shares. The corporation can now issue new common shares to the new generation at nominal value ($1). As the company continues to grow and retained earnings accumulate, the accumulation will occur in the new common shares. The frozen shares’ value doesn’t change. So when the corporation is worth $8 million, you will still own $7 million under your frozen preference shares (remember, their value does not change) and the new common shares will be worth $1 million.
Now that you own $7 million in preference shares, you can redeem them gradually over time, providing you with an annual income. You’ll pay dividend taxes on the redemption, but you can reduce the overall tax burden by spreading it over many years.
Whether you sell your business outright or by freezing, you should consult with your accountant and lawyer. Before executing freeze transactions, you’d want to ensure your agreements comply with the Income Tax Act of Canada. Any mistakes could have significant consequences (meaning you may have to pay way more taxes, penalties or interests).
If you’re selling outright, a properly drafted agreement will limit your liability and help manage your risk. While many sales go through without problems, not all do. A properly drafted agreement will offer protection. Think of it as insurance.
We offer business owners clear and understandable advice on selling a business in Manitoba. Book a free consultation with us today.