All of the great fortunes in history -- other than those of kings, queens and conquerors -- have been made by building great businesses.
In our semi-regular series on businesses and their structures, today we will focus on the succession options for businesses, and the tax considerations. There is an old saying that every business is built to be sold, so let's make sure your sale happens in the most tax-effective fashion.
We talked about the business structures available, those being sole proprietorship, partnership and incorporation. There are subgroups of each you can discuss with your accounting and legal advisers, but these categories capture the main differences in tax treatment.
As a business operates each year, proprietorships and partnerships show their gross income, expenses and net profit on the personal tax return of the owner, as we detailed on Oct. 18. This can be advantageous in the early years of the business, as net business losses can reduce taxes from other sources of income.
Corporations file their own tax return, and report their profit or loss separately from their owners. For profitable businesses with net profit under $500,000 in one year, there is a reduced small business tax rate.
But what is the tax treatment when you sell your business? (I'm glad you asked.)
When you sell a proprietorship or partnership interest, you are selling the assets of the business. This could be hard assets like business machines, vehicles, furniture and real estate. A sale could also include intellectual property or rights, such as systems, customer lists, franchise or territory agreements with other companies, or royalties and other income streams.
An intangible factor that often makes up the difference between the assets and negotiated price is a concept called goodwill.
Generally, the sale of such a business is taxable to the seller, to the extent that the selling price exceeds the cost basis for tax purposes. In limited circumstances, the sale of hard assets may be treated as a capital gain and only half taxable, but that is usually a stretch if the asset has been used in an active business. There may also be recaptured depreciation that has been claimed on those business assets.
The purchaser will have a new cost base, based on the purchase price. The seller might still face any liabilities or obligations incurred while operating the business.
Similarly, corporations can sell their assets to another corporation or to a person, and the tax treatment is comparable. However, the difference is the corporation claims the income and pays any taxes, rather than its shareholders. As well, the shareholders still own the corporation, but they have sold some or all of its assets.
A very different concept is when the shares of a corporation are sold. In this case, the purchaser buys the corporation itself, and therefore all assets or liabilities of that corporation. The seller has sold shares.
The tax treatment for the seller is a capital gain, which is only half taxable and thus more attractive, if selling at a profit.
Ideally, the corporation will be a QSBC (a Qualified Small Business Corporation, which must be a Canadian-controlled private corporation) and the shares owned by the selling shareholder for the 24 months prior to the sale. This may qualify the sellers for an exemption on the first $800,000 (in 2014) of gross capital gain on the sale of the shares.
The corporation must have been using 90 per cent or more of its assets in the active business, so it cannot be an investment holding company or one used to hoard cash.
"Purifying" corporations for this qualification is a common art among accountants. If it is your intention to sell your business at some point in the future, make sure you are well apprised of these rules and that your corporation stays within them.
David Christianson, BA, CFP, R.F.P., TEP, is a financial planner and adviser with Christianson Wealth Advisors, a vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.