For many small business owners, the end goal is to realize on their years of efforts building a successful private business corporation by selling the shares of that company. This result can be made even better if they are able to secure the significant tax benefit on that sale of shares by claiming the Lifetime Capital Gains Exemption (the “LCGE”). Indeed, the LCGE is one of the most significant tax savings opportunities available to owners of a Canadian-controlled private corporation, leading many owner-mangers to set up family trusts and engage in other tax planning opportunities to ensure they can maximize the LCGE they are able to claim.
In practice, the LCGE allows each individual shareholder to reduce the capital gain on a sale of qualifying small business corporation (“QSBC”) shares by an amount up to $892,218 as of 2021. In simpler terms, if eligible shares increased in value by up to $892,218 from the time of purchase, each individual shareholder could end up paying zero tax when the shares are sold – subject to a host of qualifications that restrict access to the LCGE.
Because of the complexity of the exemption, ensuring you have a full understanding of the eligibility requirements and other important related considerations will be essential for shareholders to benefit from this tax planning opportunity.
Which individuals are eligible to claim the LCGE?
The LCGE can generally be claimed by Canadian resident individuals who hold QSBC shares. To be considered shares of a QSBC, the following criteria must be met:
Note that shares of public corporations or corporations that are controlled (more than 50% ownership) by a combination of non-residents or public corporations do not qualify for the LCGE.
Is your business going public?
Of course the dream of many entrepreneurs is to “cash in” by taking their private small business corporations public. So how does a successful entrepreneur enjoy the benefits of the LCGE without a sale of their shares prior to going public?
Given the strict eligibility requirements to claim the LCGE, it is possible for previously-qualifying shares to become ineligible before they are sold. One common example of this loss of eligibility is when a private corporation “becomes” public. In order to benefit from the LCGE before going public, the Income Tax Act (Canada) provides an election (at s. 48.1) which allows a taxpayer to “sell” their QSBC shares for an amount of their choosing up to their fair market value and then simultaneously reacquire the shares at the chosen amount. This elected capital gain would then be subject to the normal LCGE rules.
As a result, an individual that acquired shares of a small business corporation for a nominal amount of, say, $100, who continues to hold those shares at a time when their value has increased to $1 million on the day the business goes public, could elect to “sell” those shares at an elected “price of $892,318 (if their entire LCGE was available) and reacquire the shares for exactly $892,318. This would leave them with a new adjusted cost base for tax purposes of $892,318 and allow them to avoid the applicable capital gains tax of about $240,000 (depending on your province of residence and your applicable marginal tax rate). That new adjusted cost base would be available to offset any gain on the ultimate sale of those shares in the now public company.
In order to use the election it must be claimed on the tax return for the year the business goes public. There are several significant issues associated with successfully qualifying for the going public election so you are advised to speak to your tax advisor well in advance of any “going public” transactions. Further, if the election is not claimed on time, the election can be filed late for up to two years, subject to a penalty of up to $2,400.
Further considerations when claiming the LCGE.
There are several other considerations that can affect a LCGE claim. For example, both Allowable Business Investment Losses (ABILs), that is business investment losses from sales of “small business corporation” shares to a non-related party, and Cumulative Net Investment Losses (CNILs) accrued since 1988 will reduce the amount of LCGE available. Attention should also be paid to the alternative minimum tax which can give rise to unexpected tax payable, sometimes in the tens of thousands of dollars, in years when significant deductions such as the LCGE are claimed. This tax often comes as a surprise but fortunately is recoverable in future tax years in most situations.
Questions? Let’s connect
The LCGE is a tax planning opportunity that should not be missed. Our tax team at Boughton Law has the expertise to answer any tax planning questions you may have to help you maximize your tax savings as your small business changes and grows.