The lifetime capital gains exemption (LCGE) is one of the misunderstood tax benefits offered by the Income Tax Act. Many small business owner taxpayers fall into the pitfall of claiming the LCGE on the sale of shares that don’t qualify as they thought.
What is Lifetime Capital Gains Exemption (LCGE)?
In 2022, each individual will be eligible for a life-time capital gains exemption of $913,630 and is indexed with inflation annually. The lifetime capital gains exemption allows business owners to claim tax exemptions when selling shares of qualified small busienss corporations (QSBC) . That means business owners can get $ 458,815 lifetime taxable capital gains on dispersions of qualified small business shares or qualifying farm or fishing properties.
The eligibility criteria for the LCGE
Many taxpayers believe that the shares of a Canadian-controlled Private Corporation (CCPC) automatically qualify for the LCGE when they sell their shares. However, while all QSBCs must be CCPCs, not all CCPCs are QSBC. Individuals qualify for this tax exemption, but only if they earn their capital gains from the sale of a Qualified Small Business Corporation (QSBC). To be eligible for LCGE, the following three tests must be met:
- The 90% requirement:
A company must be using 90% of its assets in active business operations inside Canada at the time of disposition. These assets include the investment in shares or debt in a connected SBC. Two companies are connected if one company controls the other or one company owns more than 10% of the shares of the other company.
- The 24-Month Period requirement:
Throughout the past 24 months, no one other than the shareholder or a person related to the shareholder has owner the shares. If a taxpayer wishes to claim the LCGE, the shares for which he or she wishes to claim the LCGE cannot have been owned by any other person in the immediately preceding twenty-four-month period. This provision prevents taxpayers from selling shares from one taxpayer without room on LCGE to another who has not yet claimed the LCGE.
- The 50% requirement:
Throughout the entire 24 month holding period, the corporation is a CCPC with more than 50% of the fair market value of its assets used in active busienss in Canada. The assets do not include shares or debt invested in a connected company.
In addition, all applicants for an LCGE must be Canadian residents for the entire tax year in which they are claiming the exemption.
The strategies for meeting the criteria
Since the lifetime capital gains exemption is fairly restrictive, you may not be able to ensure that you meet all the requirements when you sell your shares of the company.
A common strategy called purification can be utilized to meet 90% and 50% requirements. That means you can purify your company before selling your shares. To pass the test, the company must sell some of its investment assets and use the cash to buy more active business assets or pay down debt or distribute a dividend. The sales of investment will trigger capital gains of the company. However, holding period test and the 50% requirement must be met for the preceding 24 months. That means that little can be done to meet those tests in the short term.
Another option is to “crystalize” the shares. This means that a business qualifies for LCGE, and the owner claims it before time of sale. The value at which the shares were crystallized reestablishes a new and higher adjusted cost base of the shares. The owner retains their shares and receives the tax benefits at the time of crystallization, even if the business are not QSBC at the time of the actual sale.
How to file LCGE to CRA
- The Schedule 3 of personal tax return is used to report capital gains.
Capital gains = FMV – ACB – Fees or cost related to sales
FMV is Fair Market Value
ACB stands for the “adjusted cost base” – the amount initially paid for the shares
- Another form T657 is also required to file when applying for the tax exemption. The taxpayer uses this form to determine how much of the capital gains exemption will be used up (if they exceed the LCGE limit). They either preserve a portion of their exemption for future sales or must pay tax on the profits that exceed the LCGE limit.
- After the exemption calculations, the appropriate deduction will be appeared on the Line 25400 on their T1 personal income tax return.
- As the LCGE claim is a problematic area in the eye of CRA. It is suggested to maintain records and documents related to the sale of shares, and corporate tax filing copies in case you are selected for a review or audit by the CRA.
Speak to a tax accountant to make sure you meet the tests for the lifetime capital gains exemption and file your LCGE correctly.
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Resource:
https://www.canada.ca/en/revenue-agency/services/forms-publications/forms/t657.html
