Introduction - What is the Lifetime Capital Gains Exemption?
The lifetime capital gains exemption allows Canadian taxpayers to sell certain kinds of shares called qualified small-business-corporation (QSBC) shares as well as qualified farming and fishing properties without paying tax on the capital gains up to a set amount. The lifetime capital gains exemption is currently $848,252 in 2018 for dispositions of QSBC shares and is indexed to account for inflation annually. The lifetime capital gains exemption for qualified farming and fishing properties is the greater of the lifetime capital gains exemption for QSBC shares or $1,000,000. As the $1,000,000 amount is not indexed for inflation, once the indexed lifetime capital gains exemption that applies to QSBC shares exceeds $1,000,000, then the exemption for qualified farming and fishing properties will be equal to the exemption for QSBC shares.
Notably, the lifetime capital gains exemption amount is the amount of capital gains exempted. Because only 50% of a capital gain is taxable, the exemption is equivalent to an income exemption of $424,126. While the actual amount of tax an individual saves when using the lifetime capital gains exemption varies depending on their marginal tax rate, assuming the top marginal rate, an individual will save approximately $220,000 through the usage of the lifetime capital gains exemption. Call our top Toronto tax firm to learn more about the benefits and use of the lifetime capital gains exemption.
Qualifying for the Lifetime Capital Gains Exemption
Although the lifetime capital gains exemption can be very beneficial, it also has stringent rules as to when it is applicable. See our previous article for more details, but essentially there is an asset requirement, an ownership requirement, and a mixed asset-and-ownership requirement. To qualify as a QSBC, the corporation must be privately owned by an individual resident in Canada and no one other than that individual or a related person or partnership can have owned the share throughout the prior 24 months.
Furthermore, the assets of the corporation must be at least 90% principally used in an active business and at least 50% principally used in an active business for the previous 24 months. Farming and fishing properties have their own set of requirements which, in brief, require that the property be primarily used in a farming or fishing business throughout the prior 24 months, as well as require that the farm was not owned at any point over the prior 24 months by anyone other than the individual or his spouse, child, or parent, or certain partnerships or trusts, and that one of those listed people earned more gross revenue from the farming/fishing property than all other sources of revenue during that period. Speak to one of our expert Toronto tax lawyers to make sure your shares or property meet the tests for the lifetime capital gains exemption.
Crystallizing the Lifetime Capital Gains Exemption
Due to the fairly stringent requirements for the lifetime capital gains exemption, an individual may not be able to ensure that they meet all of the requirements when he decides to sell his shares of the company or his farming/fishing property as the case may be. For certain criteria such as the requirement that at least 90% of the assets of the corporation be principally used in an active business at the time of disposition of the QSBC shares, planning can be done on short notice to meet the test. Specifically, a common strategy called purification can be utilized, usually by incorporating a new holding company to hold at least 10% of the shares of the original corporation and then utilizing tax-free inter-corporate dividends to transfer any assets that are not principally used in an active business into the new holding company, allowing the original corporation to reach the 90% threshold. In some cases it may be possible to purify with a simple cash extraction.
However, several of the other requirements must be met for the preceding 24 months which means not much can be done in the short term to meet those tests. Furthermore, circumstances can change such as the corporation will no longer meet the asset requirements or the individual's shares can no longer be classified as QSBC shares. For example, the corporation's activities may change and cease to have an active business or the active business portion of the corporation will fall below the 50% or 90% requirements. Shareholdings might also change, such that the corporation is no longer Canadian controlled (i.e. other shareholders might sell their shares to non-Canadians such that the non-Canadians will own more than 50% of the shares), or that you might be considering renouncing your Canadian citizenship. In these circumstances, it may no longer be possible to fulfill the requirements for the lifetime capital gains exemption. In such a situation, the lifetime capital gains exemption can be crystallized beforehand, when the necessary tests are met, so that there is no longer any worry about meeting them in the future. There are various ways to crystallize the exemption, but ultimately they all boil down to triggering a capital gain on the QSBC shares through the use of a transaction or election. By triggering a capital gain and utilizing the exemption, the individual will increase their adjusted cost basis in whatever property he receives at the end of the transaction. The transaction is typically controlled to ensure that the capital gain being triggered is no more than the full capital gains exemption. With the adjusted cost basis increased on the property, the property can then be sold at any point in the future and the individual will have a tax savings at that point equal to the capital gains exemption amount.
To illustrate how this works, assume an individual with QSBC shares worth $800,000 that he received when the corporation was just started, so the shares have a cost basis of $1. If he sold those shares, he would normally have an income inclusion of $399,999.5 and pay approximately $200,000 in tax. If he qualified for the lifetime capital gains exemption, that entire gain would be exempt and no tax would need to be paid. To crystallize, the individual can trigger the capital gain and use the exemption to increase his cost basis to $800,000. If at a future date he decided to sell those shares and they were still worth at least $800,000, then he would realize no capital gain on the first $800,000 as the sale price would be equal to his cost basis. If the shares had increased in value to $1,000,000, he would only realize a capital gain of $200,000 and an income inclusion of $100,000 after the crystallization, compared to a capital gain of $999,999 and an income inclusion of $499,999.5 if he had not crystallized his exemption and if he no longer qualified for it at the time of sale. Essentially, crystallization locks in the benefit of the capital gains exemption which is then realized when the shares are actually sold. However, the risk of crystallizing the lifetime capital gains exemption is that the individual's exemption will be used and "locked" into those particular shares; so, if the individual is unable to sell those particular shares, he will not have realized the benefits of the LCGE and will no longer be able to use it on any other property either. Book a consultation with one of our experienced Toronto tax lawyers and see if a crystallization is suitable for your specific situation.
Tax Tip – Personalize Tax Planning for LCGE
Tax planning should always be personalized and tailored to an individual's specific circumstances. It is a no brainer to claim the lifetime capital gains exemption if possible, but as seen above, it is not as straightforward or easy to get as one might expect and, while planning can be done to meet some requirements on short notice, others have a 24 month horizon. Canadian small business owners and Canadian owners of farming and fishing properties should always be cognizant of the lifetime capital gains exemption and it is well worth the effort to ensure that you are able to claim it when you sell your QSBC shares or your farming/fishing property. Furthermore, the decision to crystallize the exemption is not always an easy one to make as there are both upsides and downsides to the decision. Our Toronto tax lawyers can help you figure out the best course of action to take and can help you set up a structure to ensure you can claim the lifetime capital gains exemption when you need to.