How can parents transfer shares in a company to their children in the most tax-beneficial way?
Taxes are one of the main considerations when it comes to a family succession. Implementing an inter-generational business transfer with minimum tax consequences requires careful consideration and can be a significant part of estate planning. It is important to consider all advantages and disadvantages before implementing an inter-generational business transfer strategy. You should consult with a qualified tax advisor regarding your specific circumstances.
Effective strategies for transferring shares in your corporation to your Child with minimum tax consequences generally include:
Minimizing capital gains tax;
Implementing an estate freeze; and
Minimizing taxes payable by your successors via life insurance.
For the purposes of an inter-generational business transfer, a “Child” includes someone who is at least 18 years of age and is:
the transferor’s or their spouse’s child, grandchild, greatgrandchild and their respective spouses;
the transferor’s or their spouse’s niece or nephew and the niece or nephew’s spouse or child; or
a person who, at any time before the person attained the age of 19 years, was wholly dependent on the taxpayer for support and of whom the taxpayer had, at that time, in law or in fact, the custody and control;
“Spouse” includes a common-law partner.
A. Minimizing Capital Gains Tax
A capital gain refers to the increase in the value of an asset that you attain when the asset is sold for more than what you paid to purchase it. Generally, individuals are exempt from having to pay taxes on capital gains income up to a certain amount in their lifetime, if they are disposing certain “qualified property”, which are dispositions of qualified farm property, qualified fishing property, or qualified small business corporation shares. The lifetime exemption amount is indexed to inflation each year.
Section 84.1 of the Income Tax Act (“ITA”) prevents taxpayers from being able to claim capital gains exemptions on the sale of their shares via non-arm's-length transactions by deeming the gain as a taxable dividend, which is subject to a higher tax rate.
However, since June 29, 2021, inter-generational business transfers are no longer subject to section 84.1. This means that the transferor can claim their capital gains exemption on the sale of their shares to a corporation that is controlled by their Child (i.e., a non-arms length transaction) when certain conditions are met (a) prior to, (b) at the time of, and (c) subsequent to the transfer.
There are two approaches for an inter-generational business transfer, either of which may be adopted:
An immediate inter-generational business transfer; or
A gradual inter-generational business transfer.
Prior to the transfer, the selling parent must not have already claimed the exception to the application of section 84.1 of the ITA for the same business, except if the disposition/transfer occurred before January 1, 2024.
At the time of the transfer, the transferor must be an individual (other than a trust). If the shares are held by a trust, prior transactions must be carried out to transfer them to the individual transferor prior to the inter-generational business transfer. The inter-generational business transfer must be made to a corporation that is controlled by the transferor’s Child, and the shares transferred must be qualified small business corporation shares.
The criteria for either approach differ only regarding the conditions to be fulfilled subsequent to the transfer. The criteria to be met for either approach is summarized in the below.
1. Control of the Business
Immediate Transfer
After the transfer, the corporation cannot be controlled (legally or factually) by the parent (and/or their spouse). This includes any relevant entity that carries on the business of the corporation.
Gradual Transfer
The legal control of the corporation must be transferred to the Child immediately. This includes the legal control of any relevant entity that carries on the business of the corporation. However, the parent (and/or their spouse) may retain some factual control of the corporation until the close of the transaction, which may be up to 10 years.
2. Economic Interest in the Business
The transferor (and/or their spouse) cannot own 50% or more of any class of common voting shares of the corporation, the purchasing corporation, or a relevant entity after the transfer for the immediate transfer option, or within 36 months for the gradual transfer option. The transferor and their spouse may continue to hold indefinitely fixed value shares that are non-voting and non-convertible.
Gradual Transfer
Within 10 years of the transfer, the transferor (and/or their spouse) cannot own debt or equity interests in the corporation, purchaser corporation or relevant group entity with a fair market value that exceeds 30% of the fair market value of all the transferor’s interests at the time of the initial transfer (Note: the threshold is 50% for a transfer of shares of a family farm or fishing corporation).
3. Management of the Business
The transferor (and/or their spouse) must take reasonable steps to:
Transfer management of the corporation and any relevant group entity to the Child who is actively engaged on a regular, continuous, and substantial basis; and
Permanently cease to manage all businesses of the corporation and any relevant group entity.
Immediate Transfer
The transfer of management of the corporation’s business to the Child must be completed within 36 months of the transfer date.
Gradual Transfer
The transfer of management of the corporation’s business to the Child must be completed within the later of 5 years and the completion of the transfer (which may be up to 10 years).
4. Retention of Control of the Business by the Child
Immediate Transfer
The Child must retain legal control of both the transferor’s corporation and the Child’s purchasing corporation for 36 months after the transfer.
Gradual Transfer
The Child must retain legal control of both the transferor’s corporation and the Child’s purchasing corporation for the later of 5 years after the initial transfer or until the close of the transaction (which may be up to 10 years).
5. Child’s Involvement in the Business
Active involvement generally means working at least 20 hours per week.
Immediate Transfer
Within 36 months of the transfer, the Child must be actively involved on a regular, continuous and substantial basis in the relevant business of the corporation (or a relevant group entity), which continues to be an active business.
Gradual Transfer
Within the later of 5 years or the completion of the transfer (which may be up to 10 years), the Child must be actively involved on a regular, continuous and substantial basis in the relevant business of the corporation (or a relevant group entity), which continues to be an active business.
Joint tax election required/ Capital gains reserve
The transferor or the Child must file a joint tax election in the prescribed form to take advantage of these proposed rules. The election must be filed on or before the transferor’s filing due date for the taxation year that includes the date of initial transfer. The Child will be jointly and severally liable for any additional taxes payable by the transferor, in respect of a transfer that does not meet the conditions. The transferor may elect and be able to claim a capital gains reserve over a period of up to 10 years.
B. Implementing an Estate Freeze
An estate freeze involves transferring the future growth of shares to your Child while retaining the current value of the shares for yourself. A common way of doing this is by exchanging your common shares in the company for fixed-value preferred shares, and then issuing common shares to your Child at a nominal price. This “freezes” the value of your shares, so that any future growth in the company’s value goes to the common shares held by your Child. Because individuals are deemed to dispose of their assets at fair market value at the time of their death, this succession strategy can decrease taxes owned by not waiting to exclusively pass on shares at death. Instead, you have an opportunity to manage/defer the tax liability associated with the post-freeze value of the company until your Child sells or gifts their shares.
Sometimes, people choose to incorporate a family trust with an estate freeze. This can be beneficial if you have not decided who your eventual successors will be, or you are still wanting to operate your business for the foreseeable future. Additionally, if you make yourself a beneficiary of the family trust, you also have an opportunity to undo the estate freeze if circumstances change and you wish to directly benefit from the future growth of your company. However, to prevent the indefinite deferral of capital gains accumulated in a trust, the family trust is deemed to dispose of its assets at fair market value every 21-years for tax purposes. Therefore, these decisions cannot be deferred indefinitely.
When implementing an estate freeze, it is a good idea to purchase enough insurance to cover the future tax liability (see below).
C. Minimizing Taxes Payable by your Successors via Life Insurance
Life insurance can be used to fund the tax liability at a business owner’s death. Corporately owned life insurance, whereby the corporation is named as the owner and beneficiary of the life insurance policy, can be beneficial. Because corporations generally have a lower income tax rate, the after-tax cost of the insurance premiums is generally less than personally held insurance. At your death, your corporation would receive the life insurance proceeds. This creates an opportunity to pay a tax-free dividend to the shareholders, who can then use various methods to address the taxes.
The proceeds from an insurance policy can also be used to keep the company going if, after your death, your beneficiaries decide that they do not want to continue with the business and choose to sell it or reorganize the company’s management.
