It’s no secret that most business owners could spend more time thinking about succession and tax planning, but there’s a $1.25-million reason to think about it – and that figure will continue to rise.
The Lifetime Capital Gains Exemption (LCGE) can be seen as a significant tax break for business owners for their contributions to the Canadian economy over years of tireless work. The exemption, which was increased in June 2024 to $1.25 million from just under $1 million in 2023, has taken on even greater importance this year following Ottawa’s changes to the capital gains inclusion rate, which increased from ½ to 2/3 for individuals realizing annual capital gains over $250,000.
The change seeks to soften the impact of the higher capital gains inclusion rate for a business owner who sells their business. John Waters, Vice President and Director of Tax Consulting Services at BMO Private Wealth addresses some of the main questions around the exemption and the value it offers business owners.
What is the LCGE?
In essence, it’s a tax incentive for individuals selling a business. There are various ways to sell your business, but the LCGE only applies if the sale meets specific tests. Typically, a business is sold through a share sale, which could entitle you to this capital gains exemption. Another approach is to sell the underlying assets within the corporation, but that would not entitle you to this exemption. So, if you want to take advantage of the LCGE, you’ll need some foresight to think about the structure of the sale.
What primary tests do owners have to pass to qualify for the exemption?
There are some very specific criteria you have to meet. One of the tests requires that the vendor is an individual who sells shares of a qualifying small business corporation (QSBC), which is a specific type of Canadian-controlled private company (CCPC). If the business is sold by another corporation, such as a holding company, it’s not going to qualify. The company must also be an active business carried on primarily in Canada, meaning it’s manufacturing something or offering professional services, instead of a passive business that simply collects rental income, interest, or dividends. Plus, at the time of the sale, at least 90% of the fair market value of all assets of the company must be used in the active business.
You also have to meet similar tests throughout the two years preceding the sale. At least 50% of the fair market value of the assets must be used in the active business and there has to be continuity of ownership over of the shares throughout those two years. That means planning ahead – at least two years – is important when you’re considering selling your business.
In addition to these corporate tests, there are other considerations imposed upon the individuals seeking to claim the LCGE – such as the Alternative Minimum Tax (AMT) or a cumulative history of claiming investment expenses in excess of investment income – that could impact your ability to access the exemption.
While Ottawa has increased the capital gains inclusion rate to increase the tax on large gains, the government also increased the LCGE to $1.25 million from $1 million. What do you think was behind that decision and what does it mean for business owners?
With the higher capital gains inclusion rate that applies to individuals on capital gains over $250,000, the government also increased the exemption amount – as of June of this year – to protect business owners. The main message here is that the value of the exemption has increased because of the capital gains inclusion rate. Without the LCGE, you’d potentially face a higher level of tax than before.
Previously, when it was around a million dollars, the exemption at the top tax rates might have saved you up to 27%, so say $270,000, depending on your province of residence. Now, if you’re saving tax at the top rates at a two-thirds inclusion rate, it’s much more valuable, up to approximately $450,000, or 36%.
Who benefits the most from the LCGE?
Small business owners will get the most bang for their buck, but for larger private companies worth tens of millions, the savings from the LCGE are not as significant, since the exemption will shelter proportionately less of the aggregate capital gain on sale.
Describe the strategies business owners can use to ensure they qualify for the exemption.
There are several strategies we always talk about involving the LCGE. The first one is purification, meaning you take steps to ensure that most of the company’s assets are primarily used in an active business. For example, if you have an investment unrelated to the operation of the business, you might try to get those assets out of the company tax-efficiently. You might buy machinery or another asset that’s actively involved in the company. Beginning at least two years before the sale, you want to make sure that you qualify for those strict tests by getting rid of those passive assets.
Another strategy is multiplication of the LCGE. If you have a successful company and the gain will be well in excess of the $1.25 million you can shelter individually, then you might look for ways to tap into the exemptions of each of your family members. To do that, you’ve got to include them in the ownership structure of the company, ideally when you start your business, so they will have a share of the purchase price when the company is ultimately sold. Oftentimes, this is done through a family trust, especially if you’re dealing with minor kids. The trust would own the shares, and then the gain realized by the trust can be allocated from the trust to the beneficiaries. Unfortunately, for an existing business, you can’t simply gift the value accrued in your hands; instead, you might embark on an estate freeze to transfer the growth in future value to other family members. For this strategy to be effective, you have to have that foresight to start early; it can be difficult to do this a year or so prior to the sale because not much growth will have accumulated in their hands.
The last strategy is something called crystallization. This is a scenario when you’re not ready to divest or sell your company today. Still, you want to access that capital gains exemption, perhaps because you’re concerned that the company may not qualify in the future. To do this, you might reorganize the ownership structure – perhaps as part of an estate freeze, and elect to create a capital gain, which you can then shelter with your exemption. At the same time, the shares you reacquire will be at that higher cost base, so you’ll have a lower capital gain when you eventually sell the company externally.
A founder may want to sell the shares of the company , but is that always in the purchaser’s best interest?
Often, there are advantages to purchasers to buy specific assets rather than the shares, which includes the whole business. On the flip side, the seller typically wants to sell the shares; they want to sell everything because they want to move on and seek to claim the capital gains exemption. That sets your goalposts at one end of the spectrum, and it sets the terms for the negotiation.
If you’ve already claimed the exemption from selling a previous business, can you claim it again for the sale of another business?
It is a lifetime exemption per individual. Until 2007, as an example, it was only at $500,000, so it’s conceivable that if you sold your business around then and used up $500,000, then you’d have another $750,000 available to you since the exemption is currently $1.25 million. The exemption will continue to increase and be indexed to inflation starting in 2026. That said, if you’ve claimed the LCGE in recent years, it will take a while to get back to a meaningful amount of the lifetime exemption available.
In your experience, is there a common mistake you see business owners make?
A lot of business owners don’t start early enough to plan for this. Typically, many start trying to plan into these provisions at the 11th hour. It’s really important to be forward thinking when you’re setting up and structuring the company. Ideally, you have all your family members as shareholders, maybe indirectly through a trust, at the inception of the business or shortly thereafter.
There are many scenarios where we’ve met with business owners who’ve come to us too late in the game. They’re so focused on running their business and don’t foresee a sale of the business (or retirement) because they’re so passionate about it. It can take over all aspects of their lives, often to the detriment of tax planning, financial planning and wealth planning, so it’s important to pause and think about these longer-term planning strategies.
