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Can you buy into a business using pretax dollars

By Stuart Morley |

Don asked:

My question is ... Can an employee buy into a business using pretax dollars that are used as a raise or would these funds be taxed first then the remainder used to buy stock in the company?

Stuart Morley answered:

Don, in Canada, acquiring shares of a private Canadian company which appreciate in value over time can represent one of the few "tax free" opportunities available to you.

While you cannot acquire shares with pretax dollars, under certain circumstances, the first $800,000 of "profit" on your private company shares can be received by you tax free (referred to as a qualified small business corporation capital gains exemption). There are certain restrictions (such as the holding period of the shares and the nature of the business that you are buying into) so it's best to get professional advice before signing up for this.

There are also a few other things that you should keep in mind before investing your money into this:

В·         While the partial tax-free aspect of this investment is very attractive, remember that you first have to have a "gain" to shelter which means that your company has to do well before you can realize your tax free gain. Never put more money into something like this if its total loss would be devastating for you. Normally there are no guarantees on the "exit" price of these shares, and they are normally tied into the performance of your company at the time that you are selling your shares.

В·         Make sure that you know how and at what value you can get your money out. These issues are typically laid out in a "Shareholders' Agreement" - an agreement that spells out the relationship between all the shareholders. This is a critical document for anyone considering a Management Buyout or Buy-in as it addresses all the "what if" questions, and makes sure everyone is in agreement on how everyone will be treated down the road, and as things change in the company and with you.

В·         Remember that you are likely to be investing for the long haul; while you might get out sooner, a safe rule of thumb is to view this as at least a 5 year investment. Again, your Shareholders' Agreement will spell out how, when and at what value you get your money out.

В·         One of the interesting things that we see happen with Management Buyouts / Buy-ins once managers become shareholders is that sometimes some of them think that the rules of the game have now changed for them and that, as a shareholder, they don’t have to work as hard or that they'll always have a say in how the business is run. Wrong! You are always an employee first and a shareholder second. You will still have a boss, job responsibilities and deadlines and results to meet. And if you don’t perform, you can still get sacked, regardless if you are a shareholder or not.

In our experience (as advisors to Management Buyouts / Buy-ins) having an ownership stake in your company is one of the best ways to create personal wealth. Aside from the tax advantage noted above, studies have proved (and most bankers will tell you) that companies that have employees as shareholders perform significantly better than those that don’t. And the better your company does, the richer you get!

If your are lucky enough to participate in a Management Buyout or Buy-in, go into this with your eyes open and be aware of the downside as well as the upside, and enjoy the real benefits of being part of something where you can truly have a direct impact on driving your personal wealth. Good luck and enjoy‼

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