What to do about the changes in capital gains tax.
Q: I am planning to sell my business in the next 5 years. What should I do in light of the proposed changes to capital gains tax?
A:
There has been a lot of discourse on social media about the proposed changes to capital gains tax announced in the most recent Federal Budget.
If you don’t know much about capital gains tax and the changes, let’s start there.
What is a capital gain?
If you sell an asset, your capital gains would equal the proceeds of selling that asset, less the cost of acquiring that asset.
So, if you sold an asset for $2 million, and you had originally paid $1 million, your capital gain would be $1 million.
What has changed?
The government announced that after June 25, 2024 you will have to pay taxes on a larger chunk of that capital gain. In previous years, you would only pay taxes on 50% of that capital gain. So in the example above, you would pay tax on $500,000 (50% x $1 million).
After June 25th - it gets a little more complicated. On the first $250,000 of your capital gain, you pay taxes on 50%. For anything above the first $250,000, you will have to pay taxes on 67% of the capital gain.
Let’s break that down for the example above:
amount of capital gain that will be taxed after June 25, 2024:
$250,000 x 50%
+
($1,000,000 - $250,000) x 66.7%
= $625,000
So, in the example above, you would pay taxes on an additional $125,000. Most of the taxpayers who earn capital gains above $250,000 (0.13% of Canadians) are in the higest tax bracket (53% in Ontario), so in the example above they would be looking at an additional $66k of taxes on a capital gain of $1 million.
Any good news?
Each Canadian does get a lifetime capital gains tax exemption on the sale of small business shares or farming and fishing property. This exemption will go up from $1,016,836 to $1,250,000. This means, that the first time you sell your business and it qualifies for the lifetime capital gains exemption, you won’t have to pay any taxes on that first $1.25 million of your gain. You can use this deduction over multiple years, on multiple qualifying sales, until you have fully utilized the full lifetime deduction.
What does this mean for the sale of my business?
Let’s look at an example: Client A, who is looking to sell their business in 5 years. They own 100% of the shares in the business and will dispose of the business as a share sale. This will be their first sale of small business shares, and therefore they will be eligible for the lifetime capital gains tax exemption of $1.25 million (this is going up from $972k). Client A’s business generates $10 million in annual revenues, earns $1.5 million in EBITDA and they are aiming to sell their business at a 5x EBITDA multiple, for $7.5 million. Since they built their business from the ground up, we assume that their capital gain would be the full $7.5 million of proceeds.
The change in tax.
Under the proposed tax changes, Client A will have to pay an additional $460k in capital gains tax, assuming they pay taxes at the highest marginal rate (53.53% in Ontario). Let’s say the sale closes in year 5, and all proceeds of the sale are paid to them at that time. Therefore in year 6, after filing and paying their taxes, Client A will have earned $460k less from the sale of their business (compared to a sale that would have happened prior to June 25th, 2024).
Are there any workarounds?
I spoke to Michele Middlemore at MC2 Business Advisors, because I was interested in knowing how she is advising her clients after the changes were announced. She shared that there are very few workarounds for businesses that will not be able to close the sale of their business before the changes are in effect on June 25th. One potential workaround would be to rollover your shares into a new corporation and crystalize capital gains before June 25th. However, she does point out that this is in no way a perfect or blanket solution and she recommends speaking to your accountant about this option, so you understand what the drawbacks and risks would be.
Plan B
Going back to Client A, who is going to now earn less money from the sale of their business. As their fractional CFO, I would work on helping them close the gap between what they would have earned before the tax changes, and what they will earn after the tax changes take effect. I would create a plan that would look at how we could increase the post-tax earnings from their business over the next 5 years, before they sell their business. If they wanted to earn another $460k after tax over the next 5 years, that would mean earning an additional $1 million in profits before tax, or about $250k per year. For a $10 million business, that means earning an additional 2% profit margin annually. Did I lose you with those numbers?
In Lehman's terms, we would look at a number of measures to increase their annual profits so they take home more money from their business over the next 5 years. For a client with $10 million in annual revenues and no Fractional CFO in the business, this is a highly plausible scenario. When I work with a business of this size, I see their profits increase by up to 100% after the first year of working together.
How is this done?
I work with CEOs and together, we create a container for effective financial management, which includes:
effective governance and standard operating procedures
a consistent and dilligent financial review process
continuous planning and forecasting
effective cash management.
The beauty of having these pieces in place, is that profit is no longer a one-time annual event on a financial statement. Profit becomes a habit that we work on continuously shaping and executing. That is what you get when you have a leader in the business that is focused on the numbers and brings a fresh perspective to every part of the business (we leave no rock unturned).