Pay Less Tax When You Sell Your Startup Business in Canada

A few simple steps, taken as your startup is growing (or even a few years before a big secondary share sale), can save founders millions in tax. Below is the practical playbook in plain English.

A Tale of Two Founders

Emma held all her shares personally. Raj issued new common shares to a discretionary family trust shortly after incorporation, kept the company “clean” for two full years, and spread the gain among four family members. Each person claimed the $1.25 million Lifetime Capital Gains Exemption (LCGE), wiping out the tax. Book a free call with CoPilot Tax to see which column you might land in when selling your startup.

Why Planning Early Matters

About two-thirds of Canadian business owners have no written succession plan.

If you miss the prep window to structure how to pay less tax in your sale, then you risk paying a lot of extra tax that you could have avoided.

Lifetime Capital Gains Exemption (LCGE)

The LCGE is a beneficial tax benefit you can get when you sell your business.

1. What it is: lets every Canadian pay no tax on $1.25 million of capital gains on  their corporation if their corporation meet some tests (called Qualified Small Business Corporation Shares (QSBCS)).

2. QSBC tests:

   • On the sale date, 90 percent or more of the corporation’s assets must be used in an active business in Canada. “Used in an active business” means the asset is used to earn business revenue, not sitting as idle cash or passive investments.

   • For each of the 24 months before the sale, at least 50 percent of assets must meet that test.

   • You (or a related person) must have owned the shares throughout those 24 months (with some exceptions).

3. What is ‘Purification’ and why is it important? It means moving excess cash, portfolio investments or real estate out of the operating company so it meets the 90 percent rule on the closing day. One common method include paying a tax-free dividend to a holding company. But be careful, there could be some unintended tax issues when you do this.

 

Need confirmation your shares are QSBCS? Contact CoPilot Tax today

Multiplying the LCGE with Family Members

Each Canadian person has their $1.25 million limit for the LCGE. A family of four could shield up to $5 million of gains, which is enough to erase tax on many early stage startups.

That means you could give your family shares of your startup so that they can use their LCGE. But that would mean they have full rights to do what they want with those shares. That may not always be a good idea if they are a minor or young adult.

There could be a better structure to make sure they don’t do that.

Family Trusts Explained

Family trusts are a great tool that lets you benefit from using your family’s LCGE but making sure they don’t actually control the shares.

Think of a family trust as a basket for a picnic. The person who owns the basket (settlor) put things in the basket (in a startup, it would be shares) into the basket. Then at a picnic, the picnic organizer (Trustees) decide who gets what from the basket (beneficiaries) get what and when. In a family trust, the trustees, which usually includes the founder) can decide who will get what each year.

Why use a discretionary trust instead of issuing shares directly to family?

• Control: the founder, acting as trustee, keeps voting power and can decide when or whether family members receive cash or shares.

• Flexibility: trustees can allocate gains to whichever family members have LCGE room or lower income.

• Privacy and probate savings: shares held in trust bypass the estate and can save tax if you pass away.

Set up the trust early and issue shares when the company is still low-value; so that future growth can accrue to your family members.

Holding Companies: When and How to Use Them

A holding company (also called Holdco) used in conjunction with a family trust is really powerful. It could be a great tool, especially for purification.

Once purified, retained earnings and intellectual property can sit safely inside Holdco. The operating company (Opco) pays inter-company dividends to Holdco, or licenses IP from it, so future creditors of Opco cannot touch those assets. However, you should be mindful if the future buyer will want to buy the IP with the startup.

A Holdco could also be a beneficiary of a trust, just like your family members. However, if you own less than 50% of your startup, this is not advisable.

Excess cash left inside an operating company is fully exposed to claims.

Putting It All Together – The Ideal Structure

The ideal structure for a startup will have the following

• A corporation – To benefit from the low tax rate corporations pay.
• A family trust – To multiply the LCGE on a sale.
• A holding company – To purify the company to make it eligible for the LCGE.

 

Putting it all together looks like this.

Want to Sell your Startup In the Future?

Contact CoPilot Tax to set up a free consultation today.