When you have worked for many years to build a valuable business, you want to ensure that when it is time to enjoy the fruits of your labour – whether it is a sale to an unrelated third party, or a sale or a transfer to a family member – the transaction should be structured to maximize your return. Before selling or transferring your business, you should meet with your accountant, your lawyer, and your financial advisor (if you have one, and if you don’t you may wish to consider retaining one), before you initiate any steps. As any sale will be impacted by various financial, legal, and tax issues, amongst others, you want to understand all of the possible legal and tax implications up front. There are two general methods by which to sell an incorporated business, which is either: 1) to sell your shares; or 2) to sell the assets of the business, and to understand the tax consequences of each type of sale.
One issue to consider in contemplating a share sale is determining whether or not you can use the capital gains exemption which is available upon a sale of shares, and whether the share sale would meet all the requirements for such an exemption. In this regard, one significant question is whether the business is an active as opposed to a passive Canadian-owned company carrying on business in Canada. On the other hand if the requirement for a capital gains exemption are not met, if the business has a significant amount of valuable assets, goodwill, and receivables, then a purchaser and a seller may prefer the structure of an asset purchase and sale. A properly-structured asset sale could enhance the sale price.
There have been some conjecture that the Canada Revenue Agency – which is always looking for more tax dollars – may eliminate the current preferential tax treatment applicable to the sale of goodwill.
In the event there is a change to the tax treatment of goodwill in the future, make sure to explore with your advisors what if anything can be done to preserve any of the benefits of the sale of goodwill now, even if you are not planning the imminent sale of your business.
A second aspect of structuring a sale of a business encompasses an “earn-out” or a “pay-out over time” as part of the purchase price. This option can take many forms and variations: it may be based on the dollar target of sales; on the retention rate of clients and customers; on the retention of senior officers or employees; or on many other factors. On an “earn-out” transaction, the buyer will pay some of the purchase price on closing and part of the purchase price from future earnings of the business; those are negotiable and tied to some or all of these factors.
From a tax perspective an “earn-out” can be treated as either payment of a portion of the purchase price, or a payment of the balance of the deferred part; alternatively – if the seller remains as an employee or as a consultant, or in a managerial role providing some services after the transaction closes – as compensation (which also allows the new owner to deduct the payment for service as an expense). In any event, if at all possible the sale should be structured so that “earn-out” proceeds received by the seller are taxed at the lower rates available for either capital gains or goodwill – otherwise these proceeds will be taxed as regular income in the seller’s hands.
The bottom line is this: Given the complexities of our Income Tax Act and its rules and regulations, and in light of C.R.A. variables – including the mood of the C.R.A. auditor at the relevant time of an audit – have your ducks lined up before you start to negotiate any sale, and before you go to the market.
Meet with your advisors and structure the form of sale which will maximize the price you obtain … and minimize the taxes you donate to C.R.A.!