Selling your business is a significant decision and there are many financial and non-financial elements for you to consider, such as the primary methods to structure the sale and the tax implications of each method.
A sale of a business is typically structured as either a sale of assets or a sale of shares. Each of these methods offers certain benefits and could be preferable depending on the circumstances. The seller often prefers a sale of shares while the buyer often prefers a sale of assets due to the differing tax implications.
On a sale of shares, the buyer purchases the equity of the company. There are a few key tax implications to consider for this type of transaction:
The profit from the sale of shares will result in a capital gain to the seller. Capital gains receive favorable tax treatment based on current tax law. Capital gains have a 50% inclusion rate which means that only half of the capital gain is taxable.
If the shares meet the criteria of Qualified Small Business Corporation (QSBC) shares, the capital gain may be eligible for the capital gains deduction. The capital gains deduction is available to individuals who recognize a capital gain on the sale of certain properties, such as QSBC shares. The deduction can be claimed to reduce the capital gain that is subject to tax. Individuals have a lifetime capital gains exemption limit of $892,218 as of 2021. Therefore, it is possible to recognize a capital gain up to this amount and receive the entire amount tax-free.
In a sale of shares, the purchaser inherits the tax attributes of your company. This includes the tax cost of your assets, such as depreciable property, and balances such as loss carry-forwards and investment tax credits. The loss carry-forwards and investment tax credits can generally only be utilized if the purchaser carries on the same or similar business.
A sale of shares is not subject to GST/HST.
In a sale of assets, the buyer purchases specific assets of the company and may take on specific liabilities as well. A sale of assets has the following tax implications that must be considered:
The buyer and the seller must agree on an allocation of the purchase price between the assets. This allocation can greatly impact the income tax implications to each party. For example, the sale of capital property may result in a capital gain and be eligible for the favorable capital gains inclusion rate. The sale of inventory will be fully taxable as business income as well.
The tax cost of each asset to the buyer will be based on the allocation of the proceeds agreed upon.
The net proceeds can be distributed to you after the capital gains and business income have been recognized in your corporation and corporate income taxes have been paid. This is typically completed by declaring a dividend to you which will be subject to tax at your marginal tax rate. The non-taxable portion of capital gains can be distributed to the shareholders by way of a tax-free capital dividend.
A sale of assets may be subject to GST/HST, as well as other taxes such as land transfer taxes.
Based on the above, you and the buyer will often have competing objectives. A sale of shares can be highly beneficial to you, especially if the sale is eligible for the capital gains deduction. A sale of shares is also a more simplistic transaction for you as it does not require an allocation of the proceeds, and the buyer assumes all assets and liabilities of the company. The previous point is often a significant drawback for the buyer: the buyer assumes all liabilities of the company, both known and unknown. The buyer is exposing themselves to a higher level of risk by purchasing the shares and typically will be unwilling to pay as much for the shares as they would for the assets as a result.
A sale of shares may be desirable to the buyer in certain situations. The brand name or reputation of the business may have value to them. As mentioned above, they may also be able to utilize loss carry-forward balances or investment tax credits if they carry on the same or similar business.
In a sale of assets, the allocation of the sale proceeds will require substantial negotiations. Your objective is to allocate the proceeds in a manner that will maximize capital gains while minimizing business income. Therefore, you will want to allocate proceeds to capital assets, particularly non-depreciable capital assets such as land. Depreciable capital assets may be subject to recapture which is taxable as business income. Similarly, profits on the sale of inventory will be taxable as business income. On the flip side, the buyer will want to maximize the allocation to inventory and depreciable capital assets. This will minimize the business income recognized on the sale of inventory to a third party and will allow for greater capital cost allowance claims on the depreciable property.
The sale can potentially be structured as a hybrid sale as well which includes elements of both an asset and share sale. A hybrid sale may help in finding a middle ground for your competing objectives. There are also many other options that can be discussed during negotiations such as contingent consideration, earn-outs, and protective clauses for certain liabilities.
Analyzing the tax implications of your alternatives is vital when planning for the sale of a business. It is best to begin this process as soon as possible as it is a valuable input to your negotiations.
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