Can we sell our respective shares back to the corporation and that way withdraw the retained earnings?
By Lloyd Lindsay | July 28, 2013
I have a small business incorporated with myself and my wife as the only shareholders (196 common shares between the two of us). The main business income for the corporation is through software consulting. The corporation has retained earnings and we are thinking of retirement.
Can we sell our respective shares back to the corporation and that way withdraw the retained earnings? What will be the tax implication? Will we benefit from 'Capital Gains exemption for small businesses'?
Lloyd Lindsay answered:
There are two ways you can sell your shares:
Sell them back to the corporation (called a redemption of shares), or 2. Sell them to a third party.
- Redemption of Shares
You appear to own a Canadian controlled private corporation. And when you redeem your shares, special tax rules apply. Basically, the Income Tax Act (ITA) treats the monies you received as a dividend received from a taxable Canadian corporation. The actual calculation for the dividend is the proceeds you received less the stated capital of the shares you redeemed. In this situation, the Capital Gains Exemption (CGE) does not apply because you are receiving a dividend and not realizing a capital gain. Also, you should obtain legal advice because a redemption of all the shares would end the existence of your corporation.
- Sale of Shares to a Third Party
If you sell your shares to a third party, you would realize a capital gain or capital loss. The calculation is the Proceeds of Disposition of the shares less the Adjusted Cost Base of your shares less your Disposal Costs. If the amount is positive, you have a Capital Gain; if it's negative, you have a Capital Loss.
You can use your CGE only against Capital Gains earned from the disposal of "Qualified Small Business Corporation" shares. And not all small business corporations qualify. For example, a small private corporation earning only investment income would not qualify. Before selling your shares, you should review the structure of your corporation with a tax professional to determine whether your corporation qualifies. If not, the tax professional may be able to help you reorganize your corporation so that it does.
Two other factors reduce the CGE you can claim: your CNIL account (Cumulative Net Investment Losses) and your previous CGE claims. In addition, beware of the Alternative Minimum Tax (AMT). Even though you expect a substantial Income Tax reduction from the CGE, the AMT may levy Income Taxes that you never anticipated.