Several years ago, brothers Bob and Doug, started a small business out of the Doug’s basement. Through hard work and dedication, their business grew and it wasn’t long before they incorporated to take advantage of the lower tax rates for small corporations.
The brothers always kept some cash in the business to take advantage of opportunities and agreed this would eventually be used to fund their retirement. However, they never really discussed their retirement plans with their accountant.
Doug is now 65 and wants to retire at the end of the year.
A Visit With The Accountant
Bob and Doug met with their accountant to discuss Doug’s retirement from the business and were a little disappointed to hear that Doug may have to wait 2 years or pay unnecessary taxes.
It seems the cash and investments retained in the business was more than 50% of the businesses assets: The corporation has $2 million in an investment portfolio and $1 million of assets used in their operating business.
The Capital Gains Deduction
In order for Doug to take advantage of the $750,000 capital gains deduction on the sale of his shares in the business, the corporation must comply with rules contained in the Income Tax Act.
First, during the two years before the sale of shares more than 50% of the businesses assets were used in an active business in Canada. The portfolio investments are not active business income
Second, no one but Bob and Doug (or a person related to them) could have owned the shares in the two years prior to the sale.
Finally, at the time of the sale, substantively all (i.e. 90% or more) of the value of the business’s assets must be used for carrying on an active business in Canada.
The Impact To Bob And Doug
In order for Doug (and Bob) to take advantage of the capital gains deduction, they need to extract more than $1 million dollars of the cash and investments from the business now and ensure no more than 10% of the investments remain in the business immediately before the sale.
There are a number of different ways to structure these transactions (which should be done with the aid of an accountant), but the brothers need to reduce the cash and investment portfolio in the business to less than 50% of the total business assets and maintain for the next two years.
Operating a business through a corporation provides a number of tax advantages and opportunities not generally available to individuals. However, corporate taxes can be quite complex and you should pay attention to your succession plan and meet with your accountant to discuss your options.