Accounting & Tax

E is for Exemption


David Chong Yen


September 13, 2013

September 13, 2013

For most dentists, one important reason to incorporate is to save tax at the time of sale, since the lifetime capital gains exemption (LCGE) allows dentists selling shares rather than assets to save up to $174,000. As of January 1, 2014, this rises to over $185,000 of savings. This tax saving can be multiplied in some cases where there are additional family members owning shares.

There are numerous tests applying both to the shareholder personally as well as to the professional/hygiene/technical corporation (PC) being sold, and if any one of them is missed, serious tax consequences can arise, so this should never be done without expert professional help. However, with careful planning, even dentists who have operated as a sole proprietor their whole career can incorporate their practice one day, and sell the next day. If you want to multiply your capital gains exemption, for example by adding your spouse, children and/or parents as shareholder(s), you must start planning at least two years before the time of sale. In addition, there must be growth in share value during the period beginning when the family member(s) first acquired the share.

The shareholder must be a Canadian resident at the time of sale. If the shareholder has claimed significant investment expenses over the years (e.g., interest paid on investment loans, or losses on tax shelters), these “investment losses” will reduce the ability to claim the LCGE. This problem too can be remedied with proper advance planning, for example by arranging to pay dividends out of the PC as “investment income” to the shareholder. If a high enough dividend is paid, the investment loss can be eliminated.

Usually, the main issue is that the PC itself is not “qualified”. The Canada Revenue Agency (CRA) only allows shares of active business companies to qualify for the LCGE, so if the PC owns too many assets such as high term deposit/GIC balances, the CRA considers it an investment company, not an active company, and will deny the dentist/other shareholders the LCGE. At the time of sale, nonactive assets (GIC’s, term deposits, etc.) cannot exceed 10 per cent by value of the total assets in the company. In addition, the CRA will count back two years from the date of sale to see if at any point during that period, the non-active assets exceeded 50 per cent of the total assets by value. This is a critical test, and very often, the only solution is to undertake careful planning at once, and then wait for two years before selling the shares. For this reason, any dentist considering selling their practice should get expert advice at least two years before the target sale date.

The non-active assets often include universal life insurance policies owned by the PC, cash and investments, buildings, or loans receivable. If the PC owns the dental building in which the practice is carried on, the building will often qualify as an active asset. However, if the dentist only occupies, for example, 25 per cent of the building and rents out the rest at arm’s length (to a third party), the building will not be considered an active business asset. There are several solutions for this problem. Sometimes, it is as easy as paying dividends and salaries out of the PC to reduce cash levels, although this will usually result in personal tax payable at that time. Other alternatives for transferring the non-active assets out of the PC are very complex, and require expert advice and long-term planning.

The LCGE can be multiplied if other family members are brought in as shareholders. Only a spouse, parents and children may own shares in your PC; however, there are no restrictions on who can hold shares in a hygiene/technical corporation. “Dividend-only shares” entitle the holder to dividends if and when declared by the dentist who holds the common (voting and controlling) shares, but otherwise give no rights to the shareholder, so many dentists use these shares to split income with family members, while retaining total effective control. However, only “equity shares” will qualify for the LCGE, so the dentist would create a second class of non-voting common shares to be issued to a non-dentist spouse, children or parents entitling the holder not just to dividends if and when declared, but to a pro rata share of the capital gains when the PC shares are sold. This approach increases the scope for tax-free proceeds to the family when the PC shares are sold, but also increases the dentist’s legal risk, since these shareholders have much more extensive rights in the event of marital breakdown, or family estrangement. This issue requires full discussion with your advisers including your accountant and family lawyer before making any decisions.

Because the LCGE offers such a huge tax advantage to sellers, it is increasingly unusual to see a practice sold as assets. If you are contemplating selling your practice in the next two to five years, you need to review your options thoroughly with your professional advisers so that you are prepared when an offer comes in, or when personal circumstances suddenly force you to sell. PA