Chapter 2: Financial Planning for Business Owners Flashcards
What is a capital gains rollover?
When a taxpayer sells a business and then invests in another business. The rollover is available when the taxpayer sells shares of a corp. that they have owned for at least 185 days, then uses the proceeds to buy shares of a different company. The newly purchased shares must be purchased from treasury (cannot purchase someone else’s shares).
What is the purpose of the capital gains rollover?
Compels the seller of a business to invest the proceeds of the sale into another business.
What are the tax consequences of a capital gains rollover?
Whatever capital gain is deferred would be applied to reduce the ACB of the newly acquired shares.
What is the purpose of the capital gains reserve?
Allows a taxpayer to spread a capital gain over several years.
What is a QSBC?
Qualified Small Business Corporation
How does the capital gains reserve work?
Allows a taxpayer to spread a capital gain over a maximum of 5 years (10 years for disposition of QSBC shares, farming property or fishing property to a taxpayer’s child). The cash exchanged for the disposition must be received in the same schedule and the gains cannot be loaded at the back (payment received must be equal to or greater than subsequent payments received).
When would the capital gains reserve be used?
If a business is being disposed of and it does not qualify as a QSBC (so the Lifetime Capital Gains Exemption is not available) or if the LCGE has been used up (or will be used up entirely by this sale).
Can variable payments based on the profitability of a business be used under the Capital Gains Reserve? What is this called?
This is called an “earn out” and would likely not be permissable as it would be taxed as income, not capital gains.
How does the Capital Gains Reserve benefit the vendor and the purchaser of a business?
The vendor benefits as the capital gains can be more easily managed.
The purchaser benefits because it encourages the vendor to take payment over multiple years (instead of all upfront).
What is the primary risk for the vendor of a business associated with using the Capital Gains Reserve?
The purchaser could default on their obligations. Even with a security agreement stating that if the purchaser defaults, the shares can be reclaimed, this poses a significant risk. If the business fails, there would be no recourse as the shares would be worthless.
How is the rollover of farming/fishing property from one generation to the next treated for tax purposes?
The transferee would inherit the property with the same tax consequences as the transferor (same ACB), assuming the continued operation that qualifies the property as a farming/fishing property.
How does a farming/fishing property qualify as having active farming income?
Property owned prior to June 18, 1987 (can be grandfathered): property must be principally (more than 50%) used in farming in the year of sale and for 5 years total in the property’s entire lifetime.
After June 18, 1987: must have been owned for 24 months prior to disposition. Must have been at least 2 years where farming income was the majority of at least one of the individual’s who owns the farm’s income and at least 2 years during which the farm was actively farmed.
What is the Elected Transfer Price in relation to farming/fishing property?
When transferring property to a “child”, the ITA allows for the selection of any price from $0 to the FMV of the property being transferred (only for farming/fishing property, otherwise double taxation would occur).
For non-depreciable assets, the child can pay with a promissory note for an amount based on the parent’s ACB + the parent’s available LCGE + any additional credits. The parent can then use their tax benefits while the childs increases their ACB without having to pay any tax at the time of disposition.
For depreciable assets, the chosen transfer price shouldn’t be higher than the Undepreciated Capital Cost (UCC) as this would result in a recapture of depreciation and the LCGE could not be used. (These assets are normally gifted to retain the parents’ UCC).
How do the rules for a rollover of farming/fishing property to a spouse work?
More restrictive than what’s available for a rollover to a child. It is not possible to elect a higher transfer price, so the assets can only roll over at a maximum of the ACB (or UCC).
How does attribution work when dealing with a spousal rollover of farming/fishing property?
If the property is rolled to a spouse during their lifetime (no attribution after death) and the receiving spouse does not work in the business, there will likely be attribution of income back to the transferor.
Who is eligible to set up a Health Spending Account (HSA)?
Incorporated business owners or unincorporated businesses with arm’s length employees.
What is the tax impact of HSA claims?
Deductible for the employer (amounts deposited to plan + fees), received tax-free by employee.
Why would a business owner avoid giving themselves a generous HSA while giving employees a significantly smaller amount?
The CRA may determine it to be a “shareholder benefit”. If that happens, the employer contributions will be disallowed and the bsuienss owner would be taxed on any benefits received.
Can income splitting via share ownership be used for a services business or professional corporation?
Not available if 90% or more of the income of the business originates from services or for Professional Corporations.
When is income splitting via share ownership allowed?
- If the shareholder who is receiving dividend income is at least 18 and works at least 20 hours per week in the business (and once this has been true at least once in the past 5 years, this right to split income is grandfathered).
- If the shareholder is 18-24 and contributed capital to the corp., they can take dividends back at the prescribed rate without any concerns about attribution. ($1000 capital at 2% prescribed rate means $20 dividends annually).
- If the shareholder is 25+ and can be shown to have acquired shares representing 10% or more of the votes and value of the opco with their own resources, no income splitting would apply.
- An owner-operator age 65+ can engage in income splitting with a spouse via share ownership, even if the business is a services business or professional corp.
What is the votes and value exemption?
If a family member age 25+ can be shown to have acquired, with their own resources, shares representing 10% or more of the votes and value of a opco, the tax on split income will not apply.
What is “kiddie tax”?
When a minor child earns dividend or interest income, that income will be taxed at the highest marginal tax rate (except for shares of publicly traded companies or in situations where a child has legitimately incorporated their own business. It also does not apply to orphans or children with no parents in Canada).
What is the purpose of “kiddie tax”?
Designed to prevent parents from establishing their minor children as shareholders of their corps as a method of income splitting.
How are dividends of private corporations taxed for minor (<18) shareholders?
Taxed in the highest marginal tax bracket. A minor child can use the dividend tax credit, but the basic exemption is not available.
What is the Lifetime Capital Gains Exemption (LCGE)?
Business owners can exempt up to ($971K in 2023, indexed from $800K in 2014) of capital gains from the sale of incorporated businesses in their lifetimes.
If the 2023 LCGE is $971K and a business owner sells their incorporated business with a $700K capital gain, how much LCGE would they have left?
$271K would be left.
Which types of property is the Lifetime Capital Gains Exemption (LCGE) available on?
- Qualified Small Business Corporation (QSBC) shares.
- Qualified farming property.
- Qualified fishing property.
What are the criteria for a business to be a Qualified Small Business Corporation (QSBC) and qualify for the LCGE?
Shares must represent ownership of a Canadian Controlled Private Corporation that is carrying on business primarily in Canada (50% or more). Must also be primarily (50% or more) engaged in active business activities within the last 24 months prior to the disposition of any assets. At the time of sale, 90% or more of the business’ assets must be dedicated to earning active business income. Seller must have owned share for 24 months prior to sale and must have been indefeasibly owned (seller is free to sell shares as he sees fit).
What does it mean to “purify” a business and when would this be done?
Often consists of transferring inactive assets to the owner of some other entity in the form of a dividend. Often done to permit the seller of a business to use the LCGE by qualifying it as a QSBC (90% or more of the business assets must be dedicated to earning active business income at time of sale).
What would happen with the LCGE if a business owner sells an opco but retains a holdco with significant passive income earning assets?
This could put the whole sale offside for the LCGE as the business must have been primarily (50%+) engaged in activities business activities in the 24 moths prior to a sale and must be almost exclusively (90%+) engaged in active business activities at the time of sale.
When would a business that earns income outside of Canada qualify as a QSBC for the LCGE?
If less than 50% of the assets of the business are dedicated to earning income outside of Canada, and more than 50% is dedicated to earning income in Canada.
What is “indefeasible ownership”?
Seller is free to sell shares as they see fit. This is a qualifier for the LCGE - it would not apply if the shares simply passed through somebody’s hands and that person was compelled to sell the shares to another party by some agreement.
How much is the LCGE for farming/fishing property?
$1,000,000, not indexed to inflation
What is considered qualifying farming property for the purpose of the LCGE?
- Shares in a family farm corporation
- Interest in a family farm partnership
- Real property used in farming
- Intangible farming assets (such as rights and quotas)
How long must a farming/fishing property be primarily used for farming or fishing purposes to qualify for the LCGE?
Primarily used for farming or fishing purposes over the previous 24 months.
What is considered qualified fishing property for the purpose of the LCGE?
- Shares in a family fishing corporation
- Interest in a family fishing partnership
- Real or immovable property (land, buildings, fishing vessel)
- Intangible fishing assets (fishing licenses and quotas)
Can a holdco sell an opco and use the LCGE?
No. Corporations cannot benefit from the LCGE. However, the owner of the holdco could sell the holdco (which would include the holdco as one of its assets) and use the LCGE, as long as the entire corp structure qualifies.
How is the LCGE impacted by investment losses claimed by a business owner?
Investment losses create a “cumulative net investment loss” (CNIL) which needs to be reduced to zero before the LCGE can be used.
Example: if someone borrows money to start a business and they pay $20,000 in interest on that loan, that can be used as a deduction. However, they have now accumulated a CNIL balance of $20,000.
What is CNIL?
Cumulative net investment loss, which is created by claiming investment losses (including interest paid on investment/business loans) and can only be reduced by investment income. A CNIL balance reduces the amount of LCGE that can be claimed.
How can a CNIL balance be reduced?
Can only be reduced by investment income - taking dividend income from an individual’s company would reduce their CNIL.
A person has $900K of available LCGE and is about to sell a business with an ACB of $500K for FMV of $1.25M. This person has a CNIL balance of $250K. How much of a capital gain will they incur? What will their CNIL be?
Capital gain from business sale = $750K (50%) = $375K - $250K (CNIL) = $125K x 2 = $250K LCGE available.
$750K - $250K LCGE available = $500K capital gain.
50% = $250K taxable income. This effectively reduces the CNIL balance to $0.
What does ABIL stand for?
Allowable Business Investment Loss
When does a CNIL balance matter?
Only if a taxpayer intends to use the LCGE.
What is often triggered by the disposition of assets accompanies by a use of the LCGE?
Alternative Minimum Tax (AMT) which is triggered when a taxpayer has a combination of a large amount of income and a low amount of tax payable.
Can expenses related to a home office be used to create a loss against other income?
No, even if a taxpayer has a qualifying home office, these expenses cannot create a loss against other income.
What does a taxpayer have to demonstrate in order to deduct business expenses for their business?
Taxpayer must demonstrate that the business is more than just a hobby - must be a bona fide business with real income earning prospects.
How are taxpayers with farming losses limited in their ability to use those losses against other income?
For farming losses to be used against other income, the farm must be the taxpayer’s principal activity. If not, their ability to use losses is limited substantially.
If a taxpayer primarily works a job and earns $50,000/year, but also owns a farm with $40,000 of revenue and $55,000 of farming losses, how much of those losses can be deducted against income?
As farming is not the taxpayer’s primary activity, only some of the farming losses are allowed. The first $40,000 of the losses can be used to directly offset the $40,000 of farming revenues. The remaining $15,000 is referred to as a restricted farm loss. The taxpayer is able to deduct $2,500 of the restricted farm loss plus 50% of the next $30,000 of losses.
As such, this taxpayer can only deduct ($2500 + (50% x $12500)=) $8,750 of farming losses against their $50,000 of primary income.
This taxpayer’s total income would be reduced to $41,250 for tax purposes.
Are farming losses deductible for a hobby farmer?
No. For farming income to be fully offset and some other income to be offset by losses, farming must be a business. If other activities are secondary in terms of time and effort, than farming losses become fully deductible.
When can losses be used for a self-employed person?
Only in the year in which they happen.
If a self-employed person has started a capital-intensive business and has no other sources of income, why may they choose to incorporate early?
Losses can only be used in the year in which they happen for self-employed individuals. Therefore, the taxpayer is likely to incur losses with little to no tax benefits. By incorporating early, the corporation can use past losses to offset future income.
What does section 85 of the Income Tax Act permit?
Permits taxpayers to transfer property to a corporation in exchange for shares without incurring tax consequences, therefore encouraging incorporation.
Why does the government generally prefer incorporated businesses over unincorporated businesses?
They provide a structure for perpetual business. A business that exists in perpetuity will pay taxes, hire employees, and spend money in perpetuity as well.
Do Section 85 rollovers result in a capital gain for the transferor of capital?
Section 85 rollovers (transferring property to a corporation in exchange for shares) should not result in any capital gains or losses or recapture of depreciation.
What forms of consideration can be taken by the transferor of property to a corporation under a section 85 rollover?
- Shares (at least one)
- Cash
- Promissory note
- Other property (fair value)
What is the easiest way to complete a section 85 rollover?
A taxpayer transfers property to a corporation in exchange for shares for the full amount.
When would a promissory note be used in a section 85 rollover?
Taxpayer wishes to transfer property to a corporation without a deemed disposition. If the corporation does not have sufficient cash to meet the elected transfer price, but the shareholder wishes to take cash at some future point, a promissory note can be used. The taxpayer then becomes a creditor of the corporation.
What is the advantage of taking a promissory note over shares when completing a section 85 rollover of property to a corporation?
Taking a promissory note puts the shareholder in the position of being a creditor of the business. Shareholders are the last ones to have any right to the assets of a failed corporation, but creditors are fairly senior. By taking a mix of both, the owner may be able to access some of the assets of their business if it fails.
What is the term for property other than shares that are taken as part of a Section 85 rollover? (Such as investments, a piece of art, etc.)
“Boot”
What are the upper and lower limits for elected transfer price of property transferred as a section 85 rollover?
Upper limit - FMV
Lower limit (for depreciable property) - the least of… the UCC, FMV, or ACB
What are the 5 types of self-employment income for sole proprietorships?
- Business income
- Professional income
- Commission income
- Farming income
- Fishing income
What is Work in Progress (WIP) accounting?
Formerly used by some professions. Allows income related to a multi-year activity to be taxed as it was received, rather than when it was earned.
How is most income earned in Canada taxed? What is the one exception?
On an accrual basis, meaning the taxpayer is taxable on the day the income is considered earned (the day a contract is signed or an invoice is issued). Taxpayers cannot defer income they are owed simply because it has not yet been paid.
One exception is for the small number of taxpayers who use cash accounting for farming income.
Who can use the cash accounting method and how does it work? What is this in contrast to?
Only applies to farming income. Under this method, the farmer does not pay tax on income until the income is received. This is in contrast to the way the rest of income is taxed in Canada, which is on an accrual basis, where taxpayers are taxed on the day that the income is considered earned.
What does a shareholder loan allow a person to do?
Allow a taxpayer to take an investment of personal capital out of their business tax free.
How are shareholder loans taxed?
A shareholder loan is taxable to the shareholder if it outstanding at the end of the fiscal year after it is taken. This rule would be triggered if there is an outstanding shareholder loan from the corporation to the same shareholder in two consecutive tax year-ends.
Is it possible to make an 18- or 19-year old child a shareholder in the business and lend the child some funds (while they’re a student with low income), creating taxable income that would be taxed at a low rate. Then once the child graduates, they would repay the loan (which would be deductible against their income) in a year when the child is earning income?
This form of tax arbitrage used to work before TOSI (tax on split income) rules applied. However, this still does work if the child has actively worked in the business. Otherwise, the TOSI rules would apply and the child would be taxed at the top marginal rate.
What would be an example of a non-tax reason for shareholder loans?
If cash is needed for personal reasons. In which case the shareholder should try to repay the loan as quickly as possible to prevent it from becoming taxable.
How is a shareholder loan taxed if taken out for personal reasons and not repaid right away?
If it becomes taxable, it’s taxable to the shareholder and not deductible to the corporation. If it is repaid, it is deductible for the shareholder and not taxable to the corporation.
When would AMT be triggered?
Alternative Minimum Tax would be triggered if a tazpayer has earned a lot of income but paid little tax.
What is a situation where a taxpayer could have earned a lot of income, paid little to no tax, and not trigger AMT?
In the year of death.
In order to recover AMT, a taxpayer must have (or create) taxable income. How can a taxpayer do this?
- CPP & OAS is taxable, any tax payable can be offset by AMT
- RRSP or RRIF withdrawals create taxable income
- Capital property could be disposed of to create a taxable capital gain
- Employment income creates taxable income
- Dividends can be taken from the taxpayer’s corp
If a farmer has had low taxable income throughout their working life, why might it still be advisable to have the farmer contribute to an RRSP?
Is the farmer is likely to one day engage in a transaction that may trigger AMT, it may be worthwhile to build RRSP assets to allow them to be withdrawn in later on to recover AMT.
What are the 2 ways an incorporated business can be sold? Which is preferred by who?
- Asset sale - preferred by most buyers
- Share sale - preferred by most sellers
What are the 3 factors that cause buyers of incorporated businesses to lean towards asset sales over share sales?
- If a buyer buys shares of companies with assets that have depreciated with a UCC less than their FMV, they will later have to pay tax on recapture of depreciation if they dispose of those assets.
- Legal liabilities of past events.
- As a potneital buyer, it doesn’t make sense to buy a business with a significant amount of non-business assets. You’re effectively converting after-tax dollars into pre-tax dollars.
Why would it make more sense for the buyer of an incorporated business to buy the business’ assets (rather than shares) if business has a considerable amount of non-business assets?
As a potential buyer, it doesn’t make sense to use your after-tax dollars to buy shares of a company that holds non-business assets as you’re effectively converting after-tax dollars into pre-tax dollars.
Why do sellers of incorporated businesses generally prefer a share sale over an asset sale?
- Seller can potentially use their LCGE on the sale of their shares (unless a holdco has been established)
- Removal of any obligations, it creates a clean break for the seller
What are (8) valid methods for splitting income with a spouse or child?
- Lend money to a spouse at a prescribed rate of interest.
- Lend/gift money to a spouse who then uses that money to start a business and earn active business income (no attribution on active business income)
- Employ a spouse or child (legitimately)
- Gift money for a pouse to put in their TFSA.
- Make a spousal RRSP contribution.
- Make the spouse a shareholder and share dividend income (respecting TOSI rules).
- Gift spouse money to invest passively. (First generation income will be attributed to source, second generation is taxed to spouse)
- Have the higher income earner pay all household expenses and make any registered invetments while the lower income earner can do all non-registered investing using their own funds.
When do TOSI rules not apply for a spouse? (3 life situations)
- Death
- Separation
- Becoming non-resident
Why would a financial institution or private lender dealing with lending to a business owner seek personal guarantees?
Financial institutions recognize that the corporation structure provides the business owner with protection from claims in case the business fails.
What is a personal guarantee?
If a corporate borrower defaults on a loan, the lender has recourse against the shareholder’s personal assets.
When is rental income not considered passive income?
If there are more than 5 full-time arm’s length employees engaged in the rental business.
Can a landlord claim depreciation (capital cost allowance) on a property?
Yes, but only the portion of the real estate that can be attributed to buildings, not land. As well, it may not be appropriate. Claiming depreciation is a form of tax deferral, so a full tax analysis should be completed to determine whether it makes sense or not. You can also choose whether to claim depreciation or not each year, it’s not mandatory.
When is claiming depreciation against a rental property less likely to pay off?
If the rental property will be sold in the near future.
What are the benefits of forming a holdco?
- Allows for differing compensation between shareholders
- Allows for succession planning by shareholders
- Crystallize a capital gain
- Protect assets from creditors
- Create distinct entities for ease of operations
How can a holding company be used to crystallize a capital gain?
Normally, the section 85 rollover provisions would be used when forming a new corporation. However, it may be possible to opt out of the section 85 rollover and elect a transfer price. By electing a transfer price, there will be a requirement to declare a capital gain. This capital gain can be offset by applying the LCGE, or possibly other tax advantages, such as an outstanding capital loss. In so doing, the taxpayer would have crystallized their capital gain. The resulting increase in the ACB would reduce any future tax burden. Note that when planning for the crystallization of any capital gain, a tax professional should be consulted.
What is an estate freeze?
The value of an estate is frozen, which allows a degree of certainty around the capital gains associated with the disposition of property.
