It is commonly understood that an individual can generally use the $750,000 capital gains exemption where they dispose of their private company shares that meet the definition of a “qualified small business corporation share” (“QSBC”). The definition of QSBC contains several technical requirements, including what is referred to as the “two year test.” The two year test generally provides that the shares will not be eligible for the exemption if they have been owned by anyone other than the individual or any person (or partnership) related to the individual within the 24 months prior to the sale. This test is usually not met where a corporation was created to start a business less than 24 months before the sale.
The Income Tax Act provides that the 24 month holding period does not apply to treasury shares issued on incorporating a sole proprietorship or partnership. Therefore, initially structuring the business as a sole proprietorship or partnership (and later incorporating the business prior to the sale) may allow for the $750,000 capital gains exemption (equal to approximately $175,000 in tax savings) that would otherwise not have been available in situations where a sale occurs within 24 months of incorporating. This strategy will not work if the sole proprietorship or partnership did not actually carry on a business prior to the incorporation of the business.
There are also other tax benefits in initially operating the business as a sole proprietorship or partnership. For instance, business losses that are realized in the early phases of a business may be used to offset other individual income (such as employment income) which would otherwise be taxed in an individual’s hands. These business losses can be carried back three years and carried forward 20 years.
If these losses were realized instead by a corporation, the losses would be “trapped” in the corporation and would only be available to offset other corporate income taxed at corporate rates, which are scheduled to decline to 25%. In Ontario, the difference between the top personal rate of 46.41% and the possible corporate tax rate of 25% is 21.41%. Personal use of the losses can cut the tax bill in half.
The individual will need balance the simplicity of operating as a sole proprietorship (or partnership) against the personal exposure to the potential liabilities of the business. At a minimum, the individual should be advised to purchase personal liability insurance as protection. As with any tax planning, practical matters such as personal liability, ease of transfer of the business, banking relationships, licensing arrangements, leases cannot be ignored.
TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.
The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.