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Ensure Your Business Qualifies as a Qualified Small Business Corporation

As a business owner, protecting your financial future is a priority. Significant opportunities lie in ensuring your company meets the rules for a Qualified Small Business Corporation (QSBC). These rules unlock valuable tax benefits, but staying compliant requires careful planning. Failure to comply with these rules can be very costly. Let’s explore how you can maximize these advantages.

QSBC Status

To be a QSBC, your business must be a Canadian-controlled private corporation and must meet these requirements:

1. At any given time, at least 90% of your company’s assets must be used in an active business carried on primarily in Canada. Excess cash or investments could disqualify your business.  There are ways to transfer the cash and investments to a holding company on a tax-free basis.

2. For at least 24 months prior to that time, 50% or more of your company’s assets must meet the active business asset criteria.

Understanding QSBC and the Lifetime Capital Gains Exemption

Owning a private Canadian corporation can make you eligible for the Lifetime Capital Gains Exemption (LCGE). This exemption allows up to $1,016,836 of capital gains to be realized by each shareholder tax-free upon the sale of your business. However, to access this benefit, your business must qualify as a QSBC.

The LCGE limit was supposed to be increased to $1,250,000 for dispositions after June 24, 2024.  Along with other proposals in the 2024 Federal Budget, this increase has died on the order paper and there is no certainty that the limit will be increased.

The Canadian Entrepreneurs' Incentive (CEI)

The 2024 Budget also proposed to introduce the CEI which would reduce the capital gains inclusion rate to half the normal rate at the time of disposition of Qualified Small Business Corporation shares provided that certain ownership requirements were met.  This provision also died on the order paper.  This Incentive was to be phased in commencing in 2025 and was to be fully implemented by 2034.

In my view, the CEI was intended to soften the blow caused by the higher capital gains inclusion rate also introduced in the Budget. 

Whether the CEI will ever see the light of day probably depends upon the introduction of a higher inclusion rate for capital gains.  If the capital gains rates do not increase, it is unlikely that the CEI will be re-introduced.

Why QSBC Compliance Matters

Whether you plan to sell your business, transfer it to the next generation, or deal with estate planning, ensuring QSBC compliance is crucial. Non-compliance could result in losing out on the LCGE—a costly mistake for any entrepreneur.

Remember, there are ways to ensure compliance with the QSBC rules during one’s lifetime, but there is no way to know if a sudden death might trigger a sale of shares for tax purposes.  The only way to ensure compliance in that case is to ensure that the company always complies with the QSBC rules.

Under current tax laws, inter-generational transfers of shares of a QSBC can also provide an opportunity to sell shares to the next generation and to withdraw cash from the business on a tax-free basis.  But again, the company must qualify as a QSBC.

Using Family Trusts

Holding QSBC shares in a family trust can provide flexibility and allow gains to be allocated among beneficiaries. This may maximize the use of LCGE across multiple individuals, since each individual is entitled to claim the LCGE.

If the company is “offside”, meaning that it does not comply with the QSBC rules, any beneficiary of the trust will have to pay tax on the capital gain generated by the sale of any shares.

Avoiding Common Pitfalls

Excess Cash Accumulation

Allowing cash to sit idle in your business can jeopardize its QSBC status. Develop a habit to regularly strip out excess funds. Stripping out excess funds and investments can usually be done on a tax-free basis, but it must be done carefully and with professional advice.  As mentioned above, you can’t plan for an unexpected death, so it is important that the company always be in compliance with the QSBC rules.

The responsibility for dealing with excess cash and investments falls to the corporation and its directors.  The following issues are unique to each shareholder, even if the corporation meets the QSBC tests.

Cumulative Net Investment Loss (CNIL)

A taxpayer having a CNIL balance will be restricted in the amount of any LCGE that he or she may claim. In general, a taxpayer will have a CNIL balance to the extent that the taxpayer’s aggregate investment expenses exceed the taxpayer’s aggregate investment income on a cumulative basis since January 1, 1988.

Capital Losses

Capital gains realized in a taxation year must generally be offset by capital losses realized during the same taxation year. Accordingly, a taxpayer realizing any allowable capital losses in the year of disposition of QSBC Shares may not be able to fully utilize the LCGE. While the taxpayer may still not be subject to tax on the gain, it may be preferable to utilize the LCGE, while it is still available, instead of a capital loss which never expires.

Allowable Business Investment Loss (ABIL)

An ABIL is like a hybrid – it is deductible like a capital loss (currently included @ 50%), but is deductible from any source of income, not just capital gains.  A claim for an ABIL at any time after 1984 may restrict the amount of LCGE available to a taxpayer. In addition, a shareholder may be restricted in his or her ability to claim an ABIL once the LCGE has been claimed.

Subsection 74.4(2) Corporate Attribution Rules - A Key Consideration

Another critical aspect of QSBC compliance involves subsection 74.4(2) of the Income Tax Act, designed to prevent income shifting within families.

If an individual transfers or loans property to a corporation that is not a QSBC this rule attributes income back to the individual transferring the property if the income benefits family members in lower tax brackets. It ensures that income from non-QSBC corporations isn’t shifted unfairly to reduce taxes.

Assume that Ms. A converts her common shares of her company to Preferred shares with a fixed value of $10,000,000 as part of an estate freeze and a family trust for lower income taxpayers acquires the common shares.  At today’s prescribed rate of interest, 4%, if the company doesn’t qualify as a QSBC, Ms. A could have an annual income inclusion in the form of interest, pursuant to subsection 74.4(2), of $400,000.  Note that this income does not reduce any income received by any beneficiaries of the trust.

Subsection 74.4(2) does not apply if your business qualifies as a QSBC, reinforcing the importance of maintaining compliance.

I’m Here to Help

Navigating QSBC rules can be complex, but crucial to your bottom line. If you’re unsure about your business’s compliance or need assistance with planning, contact me. As always, I will be happy to work with your advisors to ensure that your business remains on track for success.

--Chuck