Selling your business to your children with minimum taxation

You'll soon be handing over your business to your children. This is an important stage in your life, and you don't want to neglect either the legal or the human aspects. What about taxation? Some common mistakes could cost you a small fortune in taxes. Here's how to avoid them.

Selling your business to a family member will generate significant income, which will be taxed. Depending on how you arrange the transaction, the tax authorities will treat that income as either a capital gain or a dividend. You want them to consider it a capital gain!

Capital gain:

• Maximum tax rate of 26.6% until June 24, 2024
• As of June 25, 2024, the maximum tax rate increased to 35.54% for capital gains over $250,000
• Until June 25, 2024, the amount eligible for the capital gains deduction is $1,016,836

Dividend:

• Maximum tax rate of 48.7%
• no capital gains deduction because it’s dividend income

The $1,016,836 deduction is a lifetime maximum. For example, if you've already used a $50,000 deduction, you're only entitled to $966,836. On June 25, 2024, the capital gains deduction increased to $1,250,000. It will be indexed every year starting in 2026.

Capital gain or dividend: How they’re different

Twenty years ago, Robert founded his company with a $10,000 investment. Now he wants to sell it to his daughter Mélanie for $2 million.

She will pay him over time, from the profits. Robert must include this amount in his income tax return.

If the tax authorities consider the income to be a capital gain:

• Income: $2,000,000
• Invested capital: $10,000
• Capital gain: $1,990,000 ($2,000,000 less $10,000), and this is all the capital gains reported in 2024
• Capital gains deduction: $1,250,000 (assuming Robert has never reported any capital gains before)
• Taxable portion of Robert's capital gains: $740,000 ($1,990,000 less $1,250,000).
• Maximum tax rate: 26.6% for the first $250,000 and 35.54% for the remaining $490,000 ($740,000 less $250,000)
• Taxes payable at the highest rate: $240,646
• Robert may also have to pay the alternative minimum tax, which could be payable over a maximum of 7 years

If the tax authorities consider the proceeds of the sale to be a dividend:

• Income: $1,990,000
• Maximum tax rate: 48.7%
• Tax payable at the highest rate: $969,130

The difference: $728,484

Of course, this is just an example, and each case is different. “But capital gains is always the best strategy,” says Patrick Giroux, Senior Tax Advisor at Desjardins. And it’s all thanks to the changes announced in Bill C-208, the latest terms of which apply from 2024. Some more good news is that Quebec has aligned its tax measures accordingly.

Prior to 2024, it would have been difficult for Robert to take advantage of capital gains. The reason? Because the buyer was a family member, the tax authorities would have treated his income as a dividend. In other words, to benefit from the capital gains deduction (and as a result, pay much less tax) Robert would have had to sell his shares to an external buyer!

The new Bill C-208 corrects this inconsistency. It allows the family to structure the transaction according to their needs.

How to structure the transaction:

In the example above, Mélanie doesn’t have $2 million in cash assets. She will pay her father with the profits from the business or through a business loan.

• She will then create a holding company that will own the operating company (the “real” company).
• Robert will sell his shares in the operating company to the holding company.
• The holding company will borrow funds to pay for Robert’s shares.

For Mélanie, this financing package works in her favour. The holding company pays Robert directly, without going through Mélanie. This way, Mélanie pays no personal tax on that money. Otherwise, she would have to withdraw $4 million from the business (for example, in the form of salaries or dividends), pay $2 million in taxes, and then pay the remaining $2 million to Robert.

For Robert as well, this is a winning approach. The sale of the shares will not be considered a dividend, but a capital gain, with all the relevant tax benefits.

The transaction will have to meet certain conditions, however.

What conditions must be met?

"This only applies to the transfer of shares," warns Giroux, "not to the company's assets."

• The seller must be an individual.
• The shares sold must be eligible for the capital gains deduction.
• The acquiring company must be controlled by at least one of the seller's adult children. The term "child" has been expanded to include all direct descendants and some other family members. This means nieces and nephews can take control of the company. This expanded definition also applies to the seller's spouse's children.

In addition, conditions have been laid down to ensure a genuine intergenerational transfer of business. Criteria relating to the transfer of control, economic interests and management, the involvement of the next generation in the business and the retention of control have been developed. 

What if the conditions are not met?

Tax authorities can be strict. If any of the conditions are not met, the business transfer will be deemed a transaction between related persons. As a result, the proceeds will be considered a dividend, and the seller will be more heavily taxed.

Planning is key to success

Transferring a business is a complex transaction. For example, 2 years prior to the transaction, the business may have to dispose of some of its assets to meet the requirement that 50% of assets are used primarily for operations. As another example, the capital gain may impact alternative minimum tax or government assistance programs, such as the Old Age Security Pension. In addition, an incentive for Canadian business owners will be rolled out gradually in 2025. Your tax specialist will help you decide on the best time to complete the transaction and limit the impact. “Plan ahead!” says Giroux. More specifically, plan ahead with your accountant, tax specialist and financial institution. You need the right players on your team. Too much money is at stake!