Once, upon filing his tax return, Albert Einstein famously joked, “This is too difficult for a mathematician. It takes a philosopher.”
If one of history’s greatest minds struggled to understand the myriad tax rules that existed in his day—short form compared with today—how are business owners embarking on the sale of their companies supposed to know what to do when faced with the tax decisions related to the transaction?
The answer, of course, is to rely on experts, although tax specialists admit it’s getting increasingly difficult for even them to navigate all the regulations. “It really is as complicated as it appears,” says James Blackwell, managing partner for BDO Canada in Orangeville, Ont. “I’ve been doing tax work for some 20-odd years, and it’s getting worse all the time.”
And gray areas are on the rise, making the process even more difficult for owners.
Although each seller’s circumstances are unique, there are some general points to consider.
Shares benefit the seller
The principal decision is usually whether to sell shares of the business or its assets; or, in some cases, a combination of both.
“In general, it’s an advantage for a vendor to sell the shares,” says Jim Murdoch, a partner in the Toronto office of Thorsteinssons LLP. “The opposite is generally true for the purchasers. They usually get a better deal out of buying the assets. But you can’t say that 100% of the time.”
A primary benefit of a shares transaction is the potential for each share seller to claim up to a $750,000 capital gains tax exemption. This is a particularly advantageous strategy if the shareholders are related. “I’ve seen transactions where proper tax planning resulted in accessing six or eight capital gains exemptions for family members,” says Bryan Allendorf, regional tax leader in the Markham, Ont., office of MNP. “Parents, children, grandchildren. They could potentially shelter $4 million or $5 million of gain.”
Of course, there are certain conditions. One is that they must pay fair-market value for the shares. And they need to have held them for at least 24 months prior to sale (although there are a few exceptions).
Also, to be eligible for a capital gains exemption, 50% or more of the firm’s assets have to relate to its active business for two years leading up to the sale.
“Sellers are forced to take out their redundant assets not used in the active business,” says Blackwell. The number increases to 90% on the day of the sale. Blair Corkum, founder of Corkum & Arsenault in Charlottetown, P.E.I., has a client who’s currently struggling with the redundant assets problem.
A couple of years ago, the client purchased land through his company. “I warned him at the time that the land, and some other investments, could make him ineligible for the exemption if he wanted to sell the company in the next two years. He said that wouldn’t happen. Then someone came along and made him an offer.”
Assets benefit the buyer
A seller is likely to get a higher offer in an asset sale. Why? Purchasers prefer to buy a company’s assets because they can write them off . When they purchase shares they’re actually “buying the history of the corporation, including all its legal and employee issues,” says Murdoch. Before considering this option, however, be aware the sale of assets could result in a considerable tax hit due to recaptured depreciation.
A good solution is to negotiate a transaction that brings the seller a certain amount of the sale price in the first year and spreads the rest over a multi-year period. “That reduces how much capital gains they have to use each year and reduces the minimum tax as well,” says Corkum.
Some sellers opt for a combination share and asset sale.
A Winnipeg entrepreneur in his mid-50s sold off his Toronto professional services firm several years ago for a tidy sum. “I sold it in three parts,” he says, “two of which were asset sales, such as my client list, and a third that was a share sale.”
The share sale occurred because the suitor was buying a lucrative portion of the business that operated out of a shopping mall. “She didn’t want to have to go to the landlord and ask for permission to transfer the lease in case he rejected her,” he says. “She needed control of the company to avoid that.”
Structuring a share or asset sale is no simple matter. Sellers need to invest the time to figure out the right transactional structure. “It’s probably the biggest deal of their life. They don’t want to get it wrong, because a couple of percentage points in the tax rate can make a huge difference in how much money they can get,” says Jason Safar, a tax partner with Pricewaterhouse-Coopers in Hamilton, Ont.
He urges sellers to give tax advisors as much time as possible to help plan the deal. “I can deal with a week but I like a couple of years,” he says. “Let’s say my base point is the capital gains rate and I’m starting with an effective rate, depending on the province, of some 20%. If you give me a couple of years, maybe I can get that rate down to 5% or 10%.”
Blackwell adds, “In most cases it’s the purchaser who is going to drive the structure.” Tax specialists, unfortunately, tend to be brought in after the process has progressed to a critical point. Then their role is to “determine what the corporation’s assets consist of and what are the tax pools associated with those assets.”
This article was originally published on capitalmagazine.ca.