If you’re planning on selling your dental practice, you may have spent some time thinking about what you’ll be able to do with your hard earned money after the sale. Was paying taxes one of the things that came to mind? If you’re concerned about capital gains tax taking a bite out of your future plans, you’re in luck. There is an exemption that can save you money when it’s time to sell – the lifetime capital gains exemption (LCGE)! In this post, we will review how the LCGE works, who is eligible for it, and how it’s calculated.
What is Capital Gains Tax and the LCGE?
Let’s start with some definitions. Put simply, a capital gain is an increase in the value of a capital property, such as your dental practice, from the original purchase price. The adjusted cost base (ACB) of capital property equals the price paid for it plus any expenses paid to acquire it. Capital gains tax arises from the sale, exchange, or disposition of capital property. In Canada, if the proceeds from the sale of capital property are greater than its ACB, then 50% of that gain must be reported as income in the year that it was realized and is subject to taxes.
To see an illustration of how this works, let say
- you own 100 Common Shares of your Dentistry Professional Corporation (DPC) which was created for the purpose of purchasing a dental practice
- you paid $1 for the 100 Common Shares and then the DPC bought the dental practice for $400,000
- you are now selling the dental practice for $1,000,001
- your marginal tax rate is 50%
After the sale, your capital gain would be the sale price of – the purchase price – the ACB:
- $1,000,001 – $400,000 – $1 = $600,000
And therefore your capital gains tax owed would be half of the $600,000 capital gain multiplied by your marginal tax rate:
- ($600,000/2) x 50% = $150,000
The Lifetime Capital Gains Exemption (LCGE) is an exemption available in the Canadian Income Tax Act (the “ITA”) that provides a deduction of capital gains tax for individuals who dispose of shares of a Qualified Small Business Corporation (QSBC). The LCGE sets out an amount of the sale proceeds (indexed annually to match the rate of inflation) that is exempt from capital gains tax. In 2023, the exemption amount is $971,190. This exemption amount could be applied all in one transaction or broken up into many throughout an individual’s lifetime.
So, let’s look at the example above again and assume they are qualifying shares (which we will review next). If you have not previously used up your total LCGE amount, you wouldn’t need to pay that capital gains tax and would keep the $150,000.
When Is the LCGE Available To Me?
While there are significant dollars to be saved through the LCGE, it is important to note that strict rules apply to this exemption. Being aware of the eligibility requirements for the LCGE and organizing your DPC’s balance sheet accordingly can ensure your ability to qualify.
To qualify as QSBC shares, the ITA provides that three criteria must be met:
- the small business corporation test
- the holding period test
- the asset use test
Small Business Corporation Test
First, to qualify for the LCGE, the shares must be of a small business corporation. This means that it must be a Canadian-controlled corporation, and all (or substantially all) of the fair market value (FMV) of its assets are used in an active business carried on primarily in Canada. The position of the Canada Revenue Agency is that “substantially all,” when used in the ITA, means 90% or more of assets. So if you are a practicing dentist living in Canada and licensed by the RCDSO, you should pass this one.
Holding Period Test
Second, the shares must be owned by the dentist or their spouse/family member for at least 24 months. If you are selling because you want to retire or wind down your practice, this won’t likely be a problem. However, if you have recently acquired shares of a dental practice and want to sell them more quickly, it could be tricky. While there are workarounds to the 24-month holding requirement, including rollovers and contemporaneous closings, they are specific to each situation. Be sure to contact us at DMC to find out what is available to you.
Asset Use Test
Lastly, the assets use test has two components to consider when determining if your sale will qualify for the LCGE.
- At least 90% of those assets must be attributable to the active business at the time of the sale. This means that no assets sitting on the balance sheet are not being used or that are used for an entirely unrelated reason. In some situations, it may be necessary to take action concerning non-qualifying assets (e.g., large amounts of cash or real estate) to “purify” the balance sheet.
- At least 50% of the assets are used in the active business during the 24-month holding requirement. This means that throughout the 24-month period, 50% of the FMV of assets must be attributed to the operation of the dental practice (i.e., spending on salaries, wages, equipment, etc.). Failure to meet the asset use test during this time will restart the 24-month holding period.
If the shares are that of a Canadian-controlled corporation, held for at least 24 months, and meet both the 90% and 50% asset use test, they will be QSBC shares, and the LCGE will be available.
How to Calculate LCGE
LCGE is calculated on a gross basis. That means the amount of money that can be saved is actually the amount of tax payable based on your marginal tax rate on 50% of the allowed $971,190. So, for example, the $600,000 capital gain from the illustration above is subtracted from the LCGE allowable amount, and you earn $150,000 in tax savingsusing a 50% marginal tax rate. And, if you have never used your LCGE before, you would still have some available to use on a subsequent transaction:
Your unused LCGE would be: $971,190 – $600,000 = $371,190
There are other tax nuances you should also consider when deciding whether the LCGE works for you. Check out this post, where we review some of these, including your cumulative net investment loss, allowable business investment losses, and alternative minimum tax.
The LCGE is a powerful tool that every Canadian dentist should be aware of when considering selling their practice. It can help reduce taxes dramatically and can be used throughout your life on multiple sales. Although many requirements must be met, with the help of a dental accountant and dental lawyer, dentists selling their practices can often capitalize on this benefit. For more information on the LCGE and whether it is available to you, contact us by sending an email or give us a call at 416-443-9280.