Friday, May 24, 2024

What are the tax consequences of selling a small business I invested in to my son?


Get the value appraised before you do anything

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By Julie Cazzin with Andrew Dobson

Q: I want to sell our franchise to my oldest son. The profit year after year is $75,000 to $100,000, but sales are more than $2 million. We do not own the building; we lease it from a large company. We only own the equipment inside and the signage. I wish to sell it to my son at the fair market value I myself believe it to be, so the Canada Revenue Agency will not come back sometime in the future and request more capital gains taxes. I assess it to be worth $400,000 to $450,000. The transfer of the franchise rights to my son is free from the franchise owner and the equipment is about $250,000. Will the CRA be OK with this or will there be problems? What do you suggest I do? — Larry

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FP Answers: Transferring or selling a business to children can be a strategy for business owners to accomplish intergenerational wealth transfer. Since franchisees are bound by franchise agreements, that is likely the best place to start reviewing any restrictions regarding a sale. A franchise agreement could dictate the terms the franchisee must comply with before selling their franchise. For example, many franchises require pre-approval of new buyers/franchisees in order to allow the franchise to transfer to that new ownership.

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A business owner considering the sale of their business should consider obtaining a business appraisal to assess the value prior to the sale. Chartered business valuators (CBVs) are experts in this field and could ensure your business is properly valued, which is important for a sale involving a non-arm’s-length family member.

CBVs will check items such as equipment depreciation, sales, financial ratios (for example, price to book and price to earnings), goodwill and inventory turnover, among other items. They may also compare your business to similar, recently appraised businesses to fairly value your business.

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You made the point that determining your fair market value for the business would be important for tax purposes and that is a correct assertion. You cannot sell your business or another asset for a low value to a family member to reduce tax. The disposition is generally considered to be done at fair market value when transferring or selling assets to a non-arm’s-length recipient such as a family member.

Obtaining a valuation can ensure you are approaching this part of the transaction fairly. It could also come in useful if you decide to sell your business to a third party or if your son decides not to take over the business.

Your shares may also qualify for the lifetime capital gains exemption, which could allow you to have a capital gain of up to $1,016,836 upon the sale of shares in your business and qualify for an offsetting deduction on your taxes. This could make the sale proceeds tax free.

In order to qualify for the exemption, your business will have to pass several tests, including:

  • The qualified small business corporation test: Your business must be a Canadian-controlled private corporation.
  • The holding period test: You must have held the shares for at least 24 months preceding the sale.
  • The fair market value asset test: 24 months prior to selling your business, at least 50 per cent of its fair market value must be used in the active business. Also, at the time of sale, 90 per cent of the fair market value of the assets must have been used in the active business.

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There are a few additional considerations about how a business is taxed upon its sale. For example, you may have insurance policies, a vehicle or accumulated savings you want to extract from the business prior to the sale that may result in tax payable to you.

Or your buyer, whether your son or otherwise, could offer to buy the assets of the business, such as equipment, goodwill and the lease, instead of the shares. If your corporation sells the assets of the company, the sale would not be tax free and the company would pay capital gains tax.

Even if your share sale qualifies for the lifetime capital gains exemption, there might be a need to pay the alternative minimum tax (AMT). The AMT is levied based on a formula and can apply in situations where someone’s income tax payable is too low in any given year, but they had significant income that was subject to preferential tax treatment.

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Note that the AMT is a form of recoverable tax that can be carried forward and claimed in the future to reduce tax in a subsequent year. It may not apply to your situation specifically, but it’s good to at least mention it for others in the context of this discussion.

Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, Ont. He does not sell any financial products whatsoever. He can be reached at adobson@objectivecfp.com.

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