In a previous article entitled “The disadvantages of selling a business to family members”, we highlighted the tax consequences of selling a business to family members. In summary, selling a business to strangers is often more financially beneficial than selling to family. This is explained by the tax-avoidance rule set under section 84.1 of the Income Tax Act.
Due to this rule, selling a business to family members can result in the ineligibility of the seller to claim the lifetime capital gains exemption. Alternatively, this rule can have disastrous tax consequences for the purchasing family members as they would be forced to pay the purchase price using their personal income.
Consider the following example illustrating the application of Section 84.1 rule, the different consequences it may have on either party and as well as the future profitability of the newly purchased company.
John is the proud owner of a manufacturing company he founded 40 years ago. John’s children, Michael and Robert, have been working with their father in the family business for 10 years now. John plans to retire within the next 5 years and have his children take over the business.
Vincent, a competitor of John’s in the manufacturing industry, recently offered to buy John’s company for $1.5 million with $500,000 and the rest over 5 years. Being surprised by this incredible offer, John approached his children and explained the situation.
John, as well as Michael and Robert, always hoped the business would remain in the family. However, considering the considerable offer he received, John was considering the officer. After careful consideration, John proposed that Michael and Robert make a counter proposal in the hopes that the business can remain in the family.
In the following weeks, the children offered their proposal. They explained that they would incorporate a new company (a Holdco) and would buy their father's business for $1.5 million. They would pay this amount comprised of $100 000 in cash from their saving and fund the remainder by obtaining a 10-year loan from their father. Although this offer was not as beneficial for John, he decided to accept their offer, provided he first consult with his tax lawyer Cathy. To the satisfaction of John and his children, this offer would allow the business to remain in the family's hands.
Later that week, John met with Cathy. She explained the tax consequences resulting from the sale to his children and those pertaining to the sale to Vincent.
She explained that if John decided to sell the business to Vincent, the first $800,000 of the sale would be tax-free because he was eligible for the lifetime capital gains exemption for this amount. The remainder of the sale proceeds of $700,000 would be considered to be capital gains. Thus only $350,000 would be considered as income. Furthermore, the $350,000 would be spread out over 5 years, meaning he would be paying less tax than if he obtained the whole amount in one year. Cathy estimated that if John accepted Vincent's deal, he could make upwards of $1.3 million total in profit at the end of 5 years.
Cathy went on to explain the tax disadvantageous tax consequences that would result from the sale of his business to his children. Firstly, the sale would be subject to section 84.1 of the ITA. She explained that this rule applies when an individual sells shares in a corporation to another corporation that is owned by family members or relatives such as Michael and Robert. Secondly, the sale would produce unfavourable tax consequences for John. The money he receives from the sale would be treated as dividend income for tax purposes as opposed to capital gains. Thus, he would not have access to the lifetime capital gains exemption and no capital gain reserve. As a result of all this, she estimated he would only make $900,000. Consequently, he would be leaving $450,000 in profits on the table if he decided to accept his children's offer as opposed to Vincent's.
However, Cathy offered John an alternative. She explained that she could structure the deal his children proposed in a way that would net John the same benefits as if he sold to Vincent. In her proposition, Michael and Robert would have to pay the sale price using their own profits. They would not use a Holdco. They would have to issue themselves taxable dividends from the company's profits. Thus, they would only be able to repay their father using money they paid personal tax on. She went on to affirm that this will likely mean the children would need more than 10 years to pay the loan. Additionally, this would mean that the company's profit would have to be distributed to Michael and Robert, which in turn could negatively affect the companies cashflow. As a result, the company might not do as well, meaning John might not get his money.