Your practice is running well — it won’t be long until the practice has generated sufficient cash flow to repay your initial investment. When your practice is producing positive cash flow and your practice debt is paid off, it’s time to start thinking about how to reposition your practice so that you pay the least amount of income tax when you eventually sell.
You may be thinking that you are not anywhere close to selling your practice. You may be thinking that you may want to sell your practice in five to ten years. The reality is that circumstances change; you may end up selling your practice sooner than you think. The value of a practice has never been higher and you could receive an offer that you cannot refuse. Sometimes circumstances can also change involuntarily, such as in the case of death or disability.
Regardless of the reason why you end up selling sooner than you expect, you want to ensure that you and your family are left with the maximum after-tax cash proceeds when your practice is sold. Minimizing the income tax paid on the sale of a practice will help you achieve that goal.
How do I minimize tax on the sale of a practice?
The sale of your practice can be done by selling the practice assets or by selling the shares of your practice corporation. A benefit to selling the shares of your corporation is that you can claim the capital gains exemption (“CGE”) to offset the first $913,630 (for 2022) of the capital gain arising on sale. The income tax savings in most provinces exceed $235,000 if you are able to utilize the full CGE on the sale of your practice. The total income tax savings could be higher if your family members are also shareholders of your practice corporation.
There are certain conditions that need to be met to claim the CGE:
- The corporation is a Canadian-controlled private corporation (“CCPC”);
- An individual or a related person has owned the shares of the corporation for at least 24 months prior to the sale of shares (the “holding period test”);
- At the time of sale, the corporation has 90 percent or more of its assets being used principally in an active business carried on primarily in Canada (the “determination time test”); and
- 24 months preceding the date the shares are disposed of, more than 50 percent of the corporation’s assets have been used principally in an active business carried on primarily in Canada (the “50 percent asset test”).
What should I look for to help assess whether the CGE conditions are met?
Your corporation will start to accumulate cash when the practice is running smoothly and practice debt has been repaid. Generally, excessive amounts of cash and any other assets not needed to operate the practice are considered “bad” assets when testing whether the determination time and the 50 percent asset tests are met. Therefore, having too many non-active assets could prevent you from being able to claim the CGE.
Examples of non-active assets that can be problematic for the purposes of claiming the CGE include cash not needed for operations, publicly traded marketable securities, passive investments in private companies or real estate, life insurance policies, and loans receivable for cash lent to other businesses or individuals.
You should regularly monitor and ensure that your practice corporation is not accumulating excess cash and other non-business assets. This process is generally called purifying; the purpose of a purification is to ensure that the conditions to claim the CGE are met. Furthermore, you should frequently ask your accountant: “If I were to sell my practice, would the shares qualify for the CGE?”
If non-practice assets are accumulating, consider utilizing any or some of the following techniques:
- Pay liabilities with excess cash held;
- Pay capital dividends;
- Pay taxable dividends with excess cash or other non-active assets in-kind;
- Pay bonuses;
- Pay bonuses directly to RRSPs; and
- Reinvest in your practice.
An alternative purification technique is to transfer the non-business assets held in the practice corporation to another corporation owned by the same shareholder(s) as the practice corporation. This reorganization (referred to as a “related party butterfly”) allows the non-active assets to be transferred from your practice corporation to the other corporation on a tax-deferred basis. Ensure that you consult with your tax advisor prior to undertaking a related party butterfly reorganization to ensure it is done properly. Generally, the rules that pertain to a related party butterfly are more flexible if the butterfly is executed well in advance of a practice sale.
What if I don’t plan on selling my practice?
You may end up paying a significantly higher amount of income tax if you decide to sell your practice before you’re ready.
For example, paying yourself a taxable dividend to remove non-active assets from your professional corporation prior to sale could result in a large personal income tax liability. Also, selling or removing non-active assets from your practice corporation, such as marketable securities, prior to sale will usually trigger an income tax liability based on the excess of the fair market value over the cost of those assets. As previously noted, timing must be considered when contemplating a related party butterfly as it may not be possible to undertake this strategy too close to when the shares of a practice corporation will be sold.
What if I operate my practice as a sole proprietorship?
Practitioners that operate as a sole proprietorship may be able to utilize the CGE by transferring the practice assets from their unincorporated practice into a corporation and then selling the shares of the corporation. There is an exception to the holding period test that can allow professionals to claim the CGE when selling shares of their practice corporation without holding the shares for 24 months prior to sale. Ensure you consult with your tax advisor to ensure that your practice assets are transferred to the corporation in a way that allows this exception to apply.
MNP can help
Is your practice sale-ready? Take our SMARTPro Self-Assessment to find out.
We have a team of experts to help you navigate regulations and opportunities, and ensure your practice is ready for sale. Our income tax specialists, succession planning experts, and family office practice are all available to help you reach your goals.
To learn more, contact Michael Saxe, CPA, CA, LLM, Partner, MNP Tax Services at email@example.com or Marty Clement, CPA, CA, Partner, MNP Tax Services at firstname.lastname@example.org