Do you gift or sell your shares to your children?
If you own a small business, it's likely you spend most of your time focused on growing the businesses while often ignoring one of the most fundamental issues: transition planning.
Done properly and in advance, transition planning can ensure the business is transfered to the new owners -- whether they are family, key staff or a third party -- in the most tax-efficient manner possible.
Perhaps the most obvious plan for a family business is to transfer it to the next generation. Whether or not this makes sense, however, will depend on whether the children are already involved in the business and have the maturity and expertise to run it.
But what if one child is involved and the others are not? Or they all work in the business but you believe only one of them has the ability to successfully run it? If you don't treat your children equally with respect to equity in the business, what effect will that have on your relationships with them and similarly, relationships among the siblings?
These questions can be addressed at the outset, with a documented transition plan. Most small businesses of any significant size are structured as corporations. When transferring an incorporated business to your children, you have two options: a gift or a sale of your shares.
Your first inclination may be to gift the shares of your business in equal portions to all your children, or perhaps, only to those involved in the business. Of course, you would only contemplate this if you don't need the money from the potential sale of the shares to fund your retirement.
Making a gift, however, still has income tax consequences. You are deemed to have disposed of your shares for proceeds equal to fair market value (FMV). The difference between the FMV and the ACB of your shares will be a capital gain, of which 50% is taxable at your marginal tax rate. Capital losses you may have realized on other property, either from the current or prior years may be available to offset part of the capital gain realized on the gift.
If you choose to sell your shares to your children, you may be tempted to give them a "good deal." Be careful. You may find such a gift can result in double taxation. The tax rules state if you sell your shares to a non-arm's length party, you are deemed to receive proceeds equal to the FMV but the purchaser's new adjusted cost base (ACB) for the purpose of computing his or her own capital gain on ultimate disposition or death is only deemed to be the amount paid.
For example, let's say your business was worth $3-million and you decide to "sell" it to your son for $1-million. For tax purposes, assuming you had a negligible ACB, you will be deemed to have sold the shares for the FMV of $3-million and thus be taxable on the resultant $3-million capital gain.
Your son, however, would have an ACB of $1-million. If he were to sell the shares even a day later to a third party and realize $3-million of proceeds (the FMV), he will end up paying tax on a $2-million capital gain. Alas, double taxation on that part of the gain.
Two tax strategies can help defer or even eliminate the tax bill on the gift or sale of qualified small business corporation shares. If you take back debt instead of cash, you can defer the tax on the resultant capital gain for up to 10 years when selling to your child through the use of the capital gains reserve. Also, you may be able to permanently avoid paying tax on the gain by taking advantage of the $750,000 lifetime capital gains exemption for qualified small business corporation shares.
His report "Business Transition Planning: Unleashing the Tax Opportunities!" is available this week at www.cibc.com