The lifetime capital gains exemption (LCGE) for farmers, fishers and incorporated small business owners was increased to $750,000 in 2007.
While that is good news for farmers, you still want to make sure that any shares you hold in a family farm corporation meet the criteria that will make them eligible for the LCGE when you dispose of them.
If you have shares that currently do not meet the rules, some advance tax planning can bring them on side so they are eligible for the exemption.
Small Business Corporation Test
In order to qualify for a capital gains exemption at the time of sale, your shares must meet three specific conditions or criteria.
- The corporation must meet the definition of a small business corporation (SBC).
In other words, it must be a Canadian-controlled private corporation in which all, or substantially all, of its assets are used in an active business carried on primarily in Canada.
CRA generally interprets "all or substantially all" to mean that at least 90% of the fair market value of all corporate assets are used for business purposes.
- Either you or a person related to you must have owned the corporate shares for a 24-month period immediately prior to their sale.
- During that 24-month period, at least 50% of the corporation's assets must have been used in active business in Canada.
Not meeting all 3 conditions of the small business corporation test are where most taxpayers fall short in qualifying for the capital gains exemption.
Successful small businesses that retain their profits can quickly amass cash and investments that could be considered inactive assets, thereby making the corporation offside relative to the 90% test.
That was the situation in a court case involving the estate of a deceased taxpayer named Reilly.
The estate's executrix had claimed close to $275,000 in capital gains exemption on the deceased's final income tax return with respect to his shares in a corporation that operated four different businesses in Canada.
CRA and subsequently the appeal court denied the claim for capital gains exemption because the corporation failed the 90% test. The value of the corporation's cash and marketable securities, as a percentage of the book value of all assets, was about 38% in the year of Reilly's death and was never less than 27% during the four fiscal years preceding his death.
Qualified Small Business Corporation
Here are some steps you could consider to ensure your farm family corporation shares meet the above tests for the LCGE exemption.
You could adopt what are called purification strategies. Essentially, these are ways you can rid your corporation of inactive assets, such as excess cash or securities not used in the business, to make sure it meets the 90% test. One simple method is to remove cash from your corporation by making sufficient bonus or dividend payments.
You also could crystallize your capital gain at a time when the corporation's shares would qualify for the exemption. You could do this via a transfer of shares to a holding corporation, family members or back to the corporation or through internal share reorganization.
Then, you no longer would need to monitor whether the corporation meets the rules on an ongoing basis until you're ready to sell. Plus, it also locks in the exemption in case it should be eliminated by the government before the sale actually occurs.
Crystallization of your exemption by triggering a capital gain also can ensure your family members will reap the benefits of it if you're planning on passing on the farm business to them through succession.
The rules and purification/crystallization planning techniques can be complicated.
You should get input from a tax expert and planner to ensure the shares in your farm corporation qualify for the capital gains exemption. It would be unfortunate if you or your family missed out on the significant tax benefits of the exemption as occurred with the Reilly estate.