Succession Planning Trap

If you want to sell your Qualified Small Business Corporation to your adult children and use up your lifetime capital gains exemption (LTCGE), make sure you sell the shares directly to your children. In other words, do not sell your shares to your children's corporation. If you do, the LTCGE will be denied and the capital gain will be deemed to be a dividend. You will be left with a large personal tax bill.

For example, assume Dad wants to retire and sell Dadco at fair market value of $1,000,000. His son wants to buy Dadco and has the cash in his own company, Sonco, to do so. Dad's original paid up capital (PUC) and adjusted cost base is $100. The transaction occurs and Dad is expecting a taxable capital gain of only $66,494 [(Proceeds $1,000,000 - PUC $100 - LTCGE $866,912) x 50%].

Dad will be very disappointed to learn that his capital gain will be nil and his dividend will be deemed to be $999,900 (Proceeds $1,000,000 - PUC $100). Ouch.

This rule comes from section 84.1 of the Income Tax Act. It applies to all non-arm's length purchasers who use a purchasing corporation. Talk with a CPA if you are thinking about a possible succession plan so that section 84.1 doesn't trap you.