If you have an incorporated business, you are likely benefiting from some of the advantages of incorporation, including limited liability, tax deferral of funds reinvested in your business and the ability to initiate family planning. Want more good news? Your incorporated business may be able to benefit even further if it is considered a small business corporation (SBC) and maintains the Qualifying Small Business Corporation (QSBC) share status. Lucky for you, that is exactly what we will be talking about today.
What is a SBC?
Back to the basics, a small business corporation (SBC), is a company owned and managed in Canada.
To be considered a small business corporation (SBC), your company must:
- be a Canadian-controlled private corporation (CCPC); and
- use all, or substantially all (i.e., at least 90%), of the fair market value of the corporation’s assets in an active business; and conduct business primarily in Canada.
A holding company can also qualify as a SBC if 90% or more of its assets are shares or debts in a corporation that is a SBC. This essentially provides the holding company with the same access to the benefits associated with a SBC in a standard corporate structure.
Now, if your corporation is a CCPC that uses all of the assets in an active business, your corporation likely qualifies as a small business corporation. However, it is important to note, that if some of the assets your company owns are not being used to earn active income, then the corporation may not qualify.
An example of an asset that does not earn active income is excess cash that is invested in long-term portfolio investments. The excess cash would be earning passive income.
For shares to be considered a qualified small business corporation (QSBC) share, three tests need to be met:
- The SBC test: The corporation must be an SBC at the “particular time” – that is, any point in time in which it is necessary to determine QSBC status (e.g., in a situation where shares are being sold, this would generally be the date of disposition).
- The holding period test: The shares of the corporation must be owned by the individual, or a person or partnership related to the individual, throughout the 24 months prior to the particular time; and
- The basic asset test: The corporation must be a CCPC throughout the 24 months prior to the particular time and at least 50% of the assets must be used principally in active business in Canada.
Four reasons why you should want your business to attain and maintain its status as an SBC or QSBC
1. The lifetime Capital Gains Exemption (CGE)
The CGE allows a Canadian resident individual to shelter gains on the disposition of QSBC shares. As of 2023, Canadian-resident individuals have a lifetime limit of $971,190. This limit is indexed to inflation and will continue to increase. If you own shares of a QSBC, it is an effective tool to reduce or eliminate your tax bill that would otherwise be payable upon the sale or succession of your company.
2. Avoiding the tax on split income (TOSI) on the sale of shares
Although initially introduced in 1999, the tax on split income (TOSI) rules underwent major changes in 2017, requiring many taxpayers to revisit their small business ownership structures. The rules were extended to apply to the business owner’s spouse (or common-law partner) and adult children, as well as most other individuals who are resident in Canada and related to the business owner. If the rules do apply, split income is taxed at the top personal marginal tax rate and is not eligible for any deductions or credits, except for the dividend tax credit and foreign tax credit. However, the TOSI rules do not apply to capital gains realized on QSBC shares, whether or not the lifetime exemption has been claimed.
3. Avoiding the punitive corporate attribution rule
If your business is incorporated and you plan to add other family members as shareholders or implement an estate freeze, it is possible that the corporate attribution rules will apply. These rules are punitive in that they result in what is known as imputed interest or “phantom income”, being included in your income, whether or not you actually receive any amount from the corporation. These rules do not apply when the company is a SBC.
4. Claiming an allowable business investment loss (ABIL)
If you have invested in a company by buying shares or lending money but your investment turns out to be a dud, there is the potential to write-off half of the loss on your investment as a tax deduction. This write-off, known as an allowable capital loss, has limited deductibility. However, if the company you invested in is a SBC, the write-off could instead be considered an Allowable Business Investment Loss (ABIL), which allows for more opportunity to receive the benefit of the write-off sooner.
An ABIL is deductible against any source of income and, if no income is available in the current year, it can be deducted against any income sources in the three previous years or the next 10 years. After that time, it will still be available as a deduction, but in a more limited capacity. Therefore, the likelihood of receiving the benefit of the loss sooner rather than later is much higher if the loss is an ABIL.
How to maintain SBC/QSBC status
It is very critical to keep an eye on your balance sheet and regularly monitor your corporation’s assets to make sure your non-active business assets do not “taint” the status of your company. Steps to restore QSBC share status are often possible, but both the holding period test and the 50% test must be met for a full 24 months. If timing of the tax plan is critical, then not meeting these two tests could cause the loss of the tax benefits of QSBC share status.
It is crucial to regularly remove excess cash and non-active assets from the company. Corporate structures using a family trust and an investment holding company can be put in place to allow for the extraction of excess cash without any immediate income tax consequences.
This type of a corporate structure can also be used to multiply the benefit of the CGE by having other family members indirectly own shares in the company. This could result in significant tax savings, as each family member would be able to exempt up to $971,170 of capital gains on their QSBC shares. For a family of four, that results in almost $3.9 million of capital gains exempt from tax. This would result in a tax saving of more than $1,000,000 for the family.
If you own a valuable business, or one that will grow to a significant value, and a future share sale is possible, then it is very important to review these tax planning strategies. These types of structures need to be put in place at least three to five years prior to the eventual sale to realize the maximum benefits.
These strategies are complex from both a tax and legal perspective, however they have the potential to save significant amounts of tax. Lott & Company has the expertise to implement and maintain these strategies successfully. Reach out to one of our trusted advisors if you have any questions.
