Calculating taxable profits
Before embarking on the sale of a small business, farm, or fishing property, it’s important to fully understand how much of the profit from your sale is taxable. To calculate the amount you’re meant to pay tax on, use this simple formula: (P – L) x 0.5 where P is the profit from the sale (your “capital gains”), L is this year’s LCGE ($892,218 in 2021), and 0.5 is because half of realized capital gains are taxable. Consider the following example: You sell shares in a small business and make $1 million in profit. If it weren’t for the Lifetime Capital Gains Exemption, you’d have to pay tax on 50% of that $1 million. However, with the LCGE, rather than pay tax on $500,000, you subtract $892,218 from $1,000,000 ($107,782) and divide it in half ($53,891). You therefore end up paying tax on $53,891 instead of $500,000—quite a sizable difference.
The LCGE is cumulative
To follow on from the scenario above, let’s say you make $500,000 in profit instead of $1 million. If you were to apply the Lifetime Capital Gains Exemption, it would leave you with $392,218 to apply towards any future profit made from a sale of a second business, farm, or fishing property.
The Capital Gains Exemption in Canada keeps changing
Canada’s Lifetime Capital Gains Exemption has increased every year for a while now, and as of 2019, is indexed to inflation. See below for the amounts per year since 2014. 2014: $800,000 2015: $813,600 2016: $824,176 2017: $835,716 2018: $848,252 2019: $866,912 2020: $883,384 2021: $892,218 Note that the 2014 limit is used to index the current year’s LCGE according to the Canadian government’s Consumer Price Index, and applies to everyone regardless of whether they have previously used up the full LCGE. Another important thing to note is that farmers and fishers have a Lifetime Capital Gains Exemption of $1 million, and the terms and conditions of the program are slightly different and require particular attention. But for our purposes, let’s assume you’re a small business owner not operating in those sectors.
How to qualify for the LCGE
Firstly, the enterprise being sold must be a Canadian small business corporation, or as the Canadian government calls it, a Canadian-Controlled Private Corporation (CCPC) and all or substantially all of its assets must be used in an active Canadian business. The Canada Revenue Agency defines “all or substantially all” as at least 90% of the fair market value of all corporate assets primarily used for business purposes in Canada. Secondly, more than half of the corporation’s assets (determined on the basis of fair market value) must have been used within the 24 months immediately preceding the sale, in an active business primarily operating in Canada. Lastly, you (or someone related to you) must be the sole owner of the shares in question within the 24 months immediately preceding the sale.
If your business is unincorporated
The Capital Gains Exemption cannot be used for the sale of assets of an unincorporated business. It’s possible, however, to put these assets into a corporation and to sell the shares of the new corporation. And, if you incorporate properly, you don’t need to wait 24 months to use the exemption.
Passing the corporation to your children
It’s common in Canada for small, family-owned businesses to want to keep the corporation in the family. It’s important to know, though, that the only way to do this tax-free is to transfer shares to a spouse. If your shares are transferred to your children, the Canada Revenue Agency deems this as a sale at fair market value—and therefore eligible for the Lifetime Capital Gains Exemption. This can reduce your living family’s tax burden following your death. It’s also important to know that shares transferred to a minor child are considered split income and taxed accordingly by the federal government—and that minor children pay the highest marginal tax rate on these dividends.
This is just the beginning
While this article serves as a quick glance at the Capital Gains Exemption and what it takes to qualify, there is still a ton of additional information, exemptions, clauses, and eligibility requirements that no one person could ever hope to learn at once. It’s recommended you speak to a lawyer or accountant before selling any shares in your small business, as doing the process improperly could result in you owing tremendous amounts of tax you wouldn’t have had to pay in the first place.
