Whether you're buying or selling, when a small business changes hands, it's not just buyer beware, says one tax expert.
"You're going to have to do your due diligence," says Gabrielle Loren, a tax expert who specializes in small-business sales and partner at accounting firm Loren, Nancke & Company.
There are two basic ways to buy or sell a small business: through the sale of assets or through the sale of shares.
An asset sale is the transfer of ownership of a company's assets, such as equipment, accounts receivable, inventory and leasehold improvements. For tax purposes the price a buyer pays above the value of the individual assets is known as goodwill. The assets, including goodwill, can be written off over several years according to a formula prescribed by the Canada Revenue Agency known as depreciation. "If it's been depreciated over the years, it's probably worth more than what is listed on the books, so you've got a profit there," says Ms. Loren. The rates for deducting costs, known as capital cost allowances, differ for various assets. She says being able to negotiate the price of the assets can provide the best tax advantages.
If the business is incorporated, it may be possible to avoid any tax on a share sale by utilizing the $750,000 capital gains exemption (or whatever has not been claimed on a previous sale).
The second option is to sell the shares of the business, which involves a transfer of the assets, including the name, to the buyer. "A share sale would work really well when you've got a well-known brand name, you've got a great marketing strategy and it's something that someone else can just step in and buy," says Ms. Loren.
But the buyer also purchases any outstanding tax and legal liabilities, including employee issues such as sexual harassment suits. "You're buying the history of the company and you're buying all the skeletons in the closet at the same time. If you've had an aggressive tax person who has been writing off everything but the kitchen sink, the CRA could come along and do an audit and the new owner is responsible," she says.
Ms. Loren says a protective clause can be included in the sale agreement, but if it is not honoured voluntarily, the buyer will have go to court for reparations. She suggests contacting the CRA to ask about outstanding liabilities.
Whether it is best to transfer a company through assets or shares depends on individual circumstances. "If you have the same company for sale under the two options, you will get a lower purchase price with the share purchase because the buyer is inheriting some risk," she says.
Jack Courtney, an assistant vice-president at Investors Group, says tax rates also depend on the buyer or seller being incorporated.
He says if the purchaser is obtaining financing in a share sale or asset sale it is typically more cost effective for the buyer to be incorporated so the principal on the debt can be repaid with after-tax corporate dollars. In Ontario, for example, the top corporate tax rate is 15.5 per cent and the top personal tax rate is 46.4 per cent.
However, he says, the tax advantage for losses is greater in the higher tax bracket. "If you're going to generate losses for the first few years, maybe you don't incorporate until you're more established."
Interest paid on borrowed money is tax deductible in either case.
In the event of a share sale, the seller must be incorporated and cannot take advantage of the lifetime capital gains exemption. The share seller can only avoid taxes on the proceeds if the business is classified as active. Examples of inactive assets are stocks, bonds, excess cash or rental real estate. "Once the value of those things exceeds 10 per cent of the overall value of the assets, you don't qualify any more," he says.
Sellers will not qualify if more than 50 per cent of the value of assets are passive within two years of the sale, so Mr. Courtney says it's good to plan ahead. "If you think you're going to sell your business, and if you think it's possible to sell shares, you really need to talk with your accountant and make sure you get your balance sheet clean."
Special to The Globe and Mail
Editor's note: Tax expert Jack Courtney clarifies a statement about the $750,000 capital gains exemption in the previous version as: "If the business is incorporated, it may be possible to avoid any tax on a share sale by utilizing the $750,000 capital gains exemption."