Selling a business is a complex process, and failing to get it right can mean a big tax bill for clients. This is especially true in cases where the seller’s helping the purchaser with the sale by taking back vendor financing.
A B.C. couple in their 60s owns and operates a successful business through their holding company. Shares of the company are the holding company’s only asset. They have a nominal adjusted cost base of $1 and a fair market value of $1.4 million.
The couple’s lawyer advises them to sell the business to an employee and help finance the purchase. It’s structured as a share sale by the holding company to the employee for $1.4 million.
The terms have the holding company receiving $100,000 on signing of the agreement, with the purchaser making interest-only payments at 4.5% for the first five years. The agreement also allows the purchaser an option to renew the agreement for interest-only payments for another five-year period. So, the holding company receives $100,000 and approximately $58,500 a year in interest income—which it would have to report on its tax return—over a 10-year period.
What the Income Tax Act says
Under the Income Tax Act, a seller is entitled to defer a portion of the capital gain (called a capital gain reserve) to future years when the proceeds from the sale of a capital property are not received until after year end.
Capital gains reserve is calculated with a formula that involves proceeds received. But at least 20% of the capital gain must be reported each year over a five-year period. In our example, since the holding company is selling a capital property and not receiving the entire proceeds immediately, it would be entitled to claim the reserve.
The holding company would have to report a capital gain in its tax return for each of the next five years. The tax liability would be approximately $63,500 a year. In addition, the holding company would be subject to income tax of $26,500 every year on the interest it earns from the promissory note. This means an annual tax liability of approximately $90,000 a year in each of the next five years ($63,500 plus $26,500).
The problem is that the tax liability over the five-year period would be $450,000, while the holding company would get about $392,500 in cash ($100,000 initial payment plus $58,500 in interest for five years). That’s a cash deficiency of $57,500. When the couple negotiated the sale agreement, they failed to consider tax consequences and the resulting cash-flow problem.
Fixing cash flow
The couple asked us to solve the problem. Prior to the deal closing, we analyzed the sale agreement and found they were able to renegotiate. The couple is now selling their shares of the holding company instead of the holding company selling company shares.
This not only solves the cash flow problem, but allows the couple to use their capital gains exemption and avoid paying income tax on the sale of their shares of the holding company. They’ll end up saving more than $300,000 in tax.
Unfortunately, the couple incurred additional legal and accounting fees to renegotiate the sale agreement, which would have been avoided if they had had the right advice before agreeing to sell the business.
Michael Murphy, CA, CPA (USA), is a partner in MNP LLP’s Abbotsford, B.C. office.
Originally published in Advisor's Edge Report
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