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Lifetime Capital Gains Exemption Rules for Small Businesses Going Public

posted 2 years ago

With dreams of ringing the bell at the Toronto Stock Exchange, many small business owners have a single end game in mind: going public. An Initial Public Offering (IPO) represents the exciting moment when a private company sells its shares to the public on a major stock exchange, like the TSX, NYSE, and more.

In other words, an IPO triggers a change in ownership, transitioning its shares from the private to public spheres. While there are many benefits to the IPO process, this transition generates new challenges for taxpayers who owned shares in a company prior to it going public.

Under ordinary circumstances, selling shares of a private company entitles you to the lifetime capital gains exemption. However, an IPO alters the DNA of the corporation in question, which may endanger your eligibility. As a result, you may require advanced tax planning to take advantage of this exemption when you dispose of your shares.

What is the Lifetime Capital Gains Exemption? 

The lifetime capital gains exemption (LCGE) is a significant tax benefit for Canadians who wish to dispose of shares of a qualified small business corporation.

For the 2021 tax year, the LCGE allows you to claim an exemption from paying the income tax on the first $892,218 of gains upon disposition of qualified shares. Once this exemption is accounted for, 50% of any gain that exceeds this amount will be subject to the capital gains tax in Ontario, according to the marginal tax rate for which you qualify.

For example, if you sell shares of a qualified small business corporation for $800,000, you won’t have to pay taxes on this gain. However, if you sell shares for $1,000,000, you can subtract the exemption from your profit and pay taxes on half of the remaining gains.

For 2021, this scenario would play out in these simple calculations:

$1,000,000 – $892,218 = $107,782

$107,782 x 0.50 = $53,891

Without this exemption, you would be taxed on half of the $1,000,000, or $50,000.

As you can see, qualifying for the LCGE translates into major tax savings, which is why many shareholders hope to capitalize on this tax benefit — whether they purchased these shares on their own or collected shares as part of an employee stock option.

How large your exemption may be changes year to year, as the LCGE is indexed to account for annual inflation using the Consumer Price Index. As it stands, Canada’s inflation rate has soared to a new 31-year high of 6.7% in the largest increase to the country’s cost of living since 1991.

Regardless of the exemption’s size, it is cumulative. In other words, you don’t have to claim the entire amount at once. You can claim a fraction of the total exemption available over multiple sales. For example, if you sell $200,000 shares one year, you still have roughly $600,000 of this exemption to claim.

In some cases, business income may be earned through the disposition of shares.  However, it’s important to note that any profit you earn from selling shares generally results in capital gains vs income in Canada. However, this tax benefit still falls under the purview of the Income Tax Act.

Eligible Capital Gains: Qualifying Rules for Exemption

Like many laws found within the Income Tax Act, the LCGE has strict regulations, and only those who meet its conditions may qualify.

 Generally speaking, you can boil these rules down to the following categories of asset, ownership, and timing requirements.

  1. You must be selling shares of a qualifying small business corporation. In other words, a corporation cannot be traded on a public stock exchange.
  2. The corporation in question must be Canadian-controlled and 50% or more of its assets were in active business carried out in Canada 24 months prior to the sale.
  3. At the time of sale, more than 90% of its assets must be used in an active business.

As long as these provisions are met, taxpayers may use the LCGE when they dispose of shares of a small business. However, an IPO can make previously qualifying shares ineligible for this deduction.

Without understanding these rules inside-out, shareholders may mistakenly believe they can still take advantage of the LCGE, despite the obvious obstacle of going public. As soon as a corporation is traded on a public stock exchange, they are no longer a qualifying small business corporation.

If you think you might claim it anyway and hope to go unnoticed, you will be in for a rude awakening. The Canada Revenue Agency actively audits any return that uses the LCGE, so one of its agents will catch taxpayers who mistakenly claim the benefit when they are not entitled to the exemption.

Crystallization Offers a Time-Sensitive Workaround

This doesn’t necessarily mean all shareholders who wish to sell before, during, or after an IPO have lost their chance to capitalize on the LCGE. One of the most overlooked 2022 Canadian tax facts is that there is a possible tax strategy that may help you cash in on this exemption, provided you act fast.

Crystallization is a special and little-known election that allows you to claim this exemption after a once-qualifying small business corporation goes public. It, along with another obscure tax tip purification, ensures the corporation or sale meets the lifetime capital gains exemption test.

Purification is a paring technique done on the part of the corporation. It removes and transfers passive assets to ensure that 90% of its assets are used to carry out the active business in Canada at the time of the disposition. It usually involves a holding company to hold 10% or more of the shares so that the original corporation meets the LCGE’s 90% threshold.

Crystallization, on the other hand, is the official recognition of the profit or loss of an investment following a sale. That’s because capital gains or losses of investments aren’t recognized upon the purchase of a security. Instead, they’re only recognized when someone sells the share, formally acknowledging (or “crystallizing”) the gains or losses.

When it comes to crystallization as a tax tip for the LCGE, this process triggers a capital gain (or loss) on the qualified small business corporation shares through a transaction or election. In other words, it allows the taxpayer to sell shares and buy them back.

Crystallizing the sale of these shares means taxpayers can continue to hold the shares and sell them publicly at their convenience later without any additional tax. That’s because the taxpayer can claim the LCGE on the deemed disposition.

As a tax strategy, crystallization isn’t exclusive to the LCGE. In fact, there are many reasons why someone might crystallize their shares. Perhaps the most common one is the desire to increase or decrease book value.

Some people might sell at a loss to reduce their tax liability, repurchasing the shares with the understanding that the stock will improve in the future. Known as the superficial loss rule, this tax strategy has limitations in Canada and must be done properly to ensure you aren’t penalized.

Retroactive Crystallization: Late-Filing is Possible

If you’re denied the LCGE, there’s another option to file an election late with the Canada Revenue Agency. This process will crystalize the gain on a former qualifying small business corporation shares retroactively, including those companies that are now publicly listed.

As with any late-filing procedure, a penalty will follow this retroactive election.

The cost to late file is a penalty of $100 for every month the election is filed late, up to a maximum of $2,400. This maximum signifies there is a strict time limit on your ability to file late. You have a deadline of two years exactly from the day your T1 return was due in the same year you disposed of your shares.

Selling Shares & Going Public: Contact a Toronto Tax Lawyer for Advice

The lifetime capital gains exemption can be challenging in its own right, even when you have no doubt that you qualify for this claim.

Things get even more complicated once a corporation announces its intent to go public. The LCGE requires you to sell shares from a qualifying small business corporation, which has to be private or not listed on the stock exchange.

At first glance, you may believe your shares no longer pass the lifetime capital gains exemption eligibility test, but as you learned here today, there may be some wiggle room available.

Canadian tax advisors are an unparalleled resource for information and guidance on this subject. They can help you proactively make the right moves to ensure you can capitalize on this exemption, regardless of your corporation’s public status. They’re also available in case you unintentionally sold shares in direct opposition to these rules.

If you live in Toronto, you can seek legal and tax planning advice from Toronto tax lawyers who have a thorough understanding of the law and can guide you through this situation. Whether the company for which you own shares is gearing up for an IPO or it’s already on the market, this tax situation is easier to navigate with the right experts on your side.

Credit: roman – via FreePik

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