If you have ever sold a house, you know how involved the transaction can be before either party signs on the dotted line. As the vendor, your ultimate goal is attracting the highest price – while minimizing your tax bill. Now imagine instead of your home you are selling your business. Suddenly you are facing a number of complicated issues that you may never have expected.
Here is a list of some of the “basic” issues:
Asset Sale vs. Share Sale
The first step toward preparing your business for sale is determining how your business is structured. In Canada, corporations are owned by shareholders that are tax-paying entities that must file their own tax returns. Different liability and tax implications exist for sole proprietorships and partnerships versus corporations.
As each of these business structures possesses unique characteristics, the vendor and purchaser should understand the income tax consequences associated with each type of sale at the onset of the deal.
Negotiating The Deal
Understanding what purchasers are looking for is very important in establishing a price for your business and negotiating the deal. Purchasers generally want to acquire assets, not shares. There are a couple of key but very important reasons for this.
If someone purchases the assets of your business rather than the shares, they will have a higher income tax cost base on the assets that can potentially be deducted for tax purposes. If they purchase shares, they cannot deduct any of the “shares” purchase price and they end up inheriting the existing tax cost of those assets owned by your company.
When a purchaser buys the shares of your company, he or she also inherits any of the company’s potential liabilities, regardless of whether those liabilities are known at the time of purchase. As a vendor, you can use the tax consequences associated with an asset sale and the equivalent net proceeds on a share sale as part of the negotiation strategy.
You should first determine what the proceeds on an assets sale need to be to leave you in the same after-tax position, and proceed from there. A purchaser can potentially pay less for the shares of the company and still leave you in a better after-tax position, resulting in a win-win for both parties.
As a small business corporation, removing or transferring the non essential assets that are not part of your business operations is another key step in preparing your business for a share sale. These assets could include real estate holdings, excess cash, investments not to be sold with the company, or semi-personal assets you would like to keep, such as vehicles, etc.
In the case of your real estate holdings, we advise taking a strategic approach to removing your assets. If you company owns real estate, consider transferring it to a separate holding company utilizing Section 85 of the Income Tax Act.
Transferring the real estate to a holding company can make it easier for potential buyers to acquire your company, since the cost of the business will be lower if they do not have to acquire the real estate.
Having the real estate in a company separate from your operations is generally a very good idea regardless of whether the business is sold, as it can protect the real estate from risks associated with the business operations.
Selling your business without the real estate can also be particularly helpful, as it expands the list of potential buyers to include parties who previously may not have been able to secure sufficient financing to acquire your business and real estate assets.
You can then lease the property to the purchaser on a commercial basis, which will provide you with an ongoing income stream as well as potential appreciation in the value of the property.
Remember that when removing assets from your company, you should be aware of the many potential tax issues that need to be addressed to avoid any negative income tax consequences. Proper professional advice is mandatory for these types of transactions, so please call us.
Accessing The Capital Gains Deduction
One reason vendors prefer selling shares versus assets is the possibility of significant income tax deductions. For example, businesses that qualify for the capital gains deductions on the shares of a small business corporation may have access to a potential tax savings of up to $172,500.
As the vendor, it is vital you know up front whether you can use the deduction. To figure this out, we suggest having us conduct a review to determine whether the company’s shares qualify for the capital gains deduction and whether shareholders have access to it.
Your Chartered Accountant should also complete a thorough review of your personal tax history, which is a mandatory step in the process to ensure nothing in your tax history would preclude access to the capital gains deduction. Previous use of the capital gains deduction, cumulative net investment losses and previous allowable business investment loss claims could restrict your access to the deduction
Detailed income tax rules related to the definition of “qualified small business corporation share” also need to be reviewed to determine whether the shares will qualify. In some cases, you may be able to take steps to make the company qualify prior to a sale.
Agreeing on the value of your business may be a source of contention between you and the potential buyer. In this case, you have a number of options available.
As the vendor, you may think that based on future earning capacity, your company should be worth “x” amount of money. If a purchaser is not convinced your company can actually generate that level of earnings, they may agree to pay your price, but only on the condition your earnings reach those levels.
This type of arrangement is referred to as an “earn-out” and can be a good effective method of structuring the sale in which some disagreement exists about the future earnings, and thus the value of the business.
From an income tax perspective, earn-outs need to be structured very carefully to help ensure payments are treated as part of the share selling price, not as regular income to you.
To achieve capital gains treatment on the earn-out component, the transaction should be structured as a “reverse earn-out.” A reverse earn-out is set up so the selling price in the purchase and sale agreement is set at the maximum possible, assuming the earnings levels will be achieved.
When preparing a business for sale, please contact us to assist you and help ensure tax considerations are examined and structured properly throughout each stage of the transaction.
The more prepared you are during the planning and structuring of the deal, the greater your chances for a smooth, tax-effective transactions.
Please Call Us Today at 905-528-0234 to Discuss Any Concerns You May Have or email Joe at [email protected].