As the owner of an active business corporation, you’ve probably heard about the lifetime capital gains exemption that can apply to the sale of qualifying private company shares. If you and your family members can claim this exemption when you sell the shares of your business, you could each realize substantial tax savings, providing that the shares you’re selling meet certain requirements.
Every individual is entitled to a lifetime “capital gains exemption” on qualifying small business shares (and farm and fishing property). This exemption, which is indexed for inflation annually, is limited to a lifetime amount of $892,218 for 2021 (and $913,630 for 2022). It’s important to note that you don’t have to claim the exemption all at once – you can carry forward any unused amount to use in the future.
Three Tests to Qualify for a Capital Gains Exemption
To qualify for the exemption, three tests must be met at the time of disposition.
Small Business Corporation (SBC) Test
All, or substantially all, of the company’s assets must be used in an active business carried on primarily in Canada. “All or substantially all” is generally considered to mean at least 90%, using fair market value. Only the company’s assets are considered in the criteria; debt and other liabilities have no impact. Assets not listed on the balance sheet are also included, such as goodwill and internally generated patents. The reference to “primarily in Canada” generally means at least 50%.
Holding Period Test
The disposed share must have been owned by the shareholder or a related person throughout the 24-month period prior to the disposition. This is an attempt to limit the CGE to longer-term investments rather than rewarding quick flips.
Basic Asset Test
Throughout the 24 months prior to the disposition, the corporation had to have been a Canadian-controlled private corporation and more than 50% of the company’s assets had to have been used in an active business carried on primarily in Canada.
Capital Gains Exemption Example:
You sell shares of a small business corporation in 2023 and make a $1,000,000 profit (also called capital gains). Without the LCGE, you would have to pay taxes on half of this amount, i.e., $500,000. However, seeing as the LCGE allows you to subtract $971,190 from your profits in 2023, you only pay taxes on ($1,000,000 – $971,190) x 50% = $14,405 rather than on $500,000.
Watch out for these pitfalls
The alternative minimum tax (AMT) can cause an unexpected tax liability in the year CGE is claimed. Generally, this can occur when a taxpayer crystallizes in a year of otherwise low income. While AMT is refundable, a refund is generated only when AMT is less than the regular tax calculation in the subsequent seven years.
- A balance in a taxpayer’s cumulative net investment loss (CNIL) account can restrict access to the CGE. As the name implies, this is a cumulative calculation that considers all of an individual’s investment income and investment expenses incurred after 1987. If the calculation results in a net loss, the CNIL could impact a CGE claim.
- An allowable business investment loss (ABIL) could impact a CGE claim. If an ABIL is realized in the year, whether or not it is claimed on the tax return, it is used in the CGE calculation.
If you are considering selling the shares in your active business corporation, please contact us to discuss what steps you should take to ensure that you benefit fully from the Lifetime Capital Gains Exemption.