The $800,000.00 Capital Gains Exemption, Common Shares & Family Members

General As many of you already know a dentist can add a family member (being a spouse, children and parents of the dentist) as a non-voting shareholder of the dentistry professional corporation (the “DPC”).

As we tell all of our clients your spouse should be added as a non-voting shareholder when you incorporate. If both you and your wife are shareholders of the DPC on incorporation (or before the shares have appreciated in value) both the dentist and spouse can each enjoy the lifetime $800,000.00 capital gains exemption being $1,600,000.00 in the aggregate to shelter capital gains and hopefully pay no tax on a sale of common shares (for the purposes of his article “Common Shares” mean shares that will grow as the value of the DPC grows) of a DPC.

It is possible that the dentist has a CNIL (cumulative net investment losses) problem on a sale resulting in the dentist not being able to utilize his or her capital gains exemption. The CNIL account of the dentist does not affect the ability of the spouse, if a common/equity shareholder, to enjoy his or her $800,000.00 capital gains exemption.

There are, however, reasons why you may not want to add other non-spouse family members as common or equity shareholders as noted below.

Adding a Spouse

On discussing the incorporation of a DPC we are often asked whether the dentist should add their spouse as a common shareholder of the DPC and generally we recommend it. Even after incorporation we can add the spouse but it is much more costly.

Unfortunately, we get phone calls far too often from clients who have not added their spouse as a common shareholder and are now planning on selling the shares of their DPC and have determined that the capital gains on such sale will exceed their own $800,000.00 exemption. They then ask us whether they can add their spouse as a common shareholder to their DPC in order that their Spouse can also enjoy the Capital Gains Exemption. Is it possible? Yes, but it does come with risks. Take the following fact scenario.

Fact Scenario – Issuing Common Shares to Spouse before a Sale

A dentist in Ontario is the sole shareholder of shares of his DPC and enters into or is about to enter into an agreement to sell the shares (in this example the dentist owns 1000 Class A Non-Voting Common Shares and 1 Class B Voting Common Share) at a sale price of $1,600,000.00. The dentist had never made the spouse a shareholder. The dentist meets with us and accountant and determines that the gain over the dentist’s cost base for the dentist’s shares (assume that the cost base is nominal/nil) is $1,600,000.00. As the sole shareholder of the DPC the dentist in this scenario would be entitled to the $800,000.00 capital gains exemption but the remaining gain of $800,000.00 would realize tax of approximately $200,000.00 netting the dentist $1,400,000.00. The dentist asks us and the accountant whether there is any reorganization that can be done for the DPC to add the dentist’s spouse as a shareholder before the sale in order that the spouse could also utilize the spouse’s $800,000.00 capital gains exemption and thereby save the $200,000.00 tax (or at least part of it).

Proposed Method of issuing Common Shares to Spouse before Sale

Subject to the risks noted below, it is proposed that the dentist would undertake 2 transactions in regard to the dentist’s 1000 Non-voting Common Shares (the dentist cannot simply sell all of the non-voting common shares to the spouse:

1. In the 1st transaction the spouse purchases 500 of the dentist’s 1000 Non-Voting Common Shares from the dentist at fair market value (as the anticipated sale price in the above example will be $1,600,000.00 the fair market value and the cost base of the shares purchased by the spouse from the dentist will have a cost base of $800,000.00) and pays by promissory note with interest at the prescribed rate (approximately 1% per annum). The dentist would realize a gain of $800,000.00 (sale price of $800,000.00 less the nominal/nil cost base) on the sale of the 500 Non-Voting Common Shares to the spouse which gain would be sheltered by the dentist’s lifetime $800,000.00 capital gains exemption (the dentist would elect out of the spousal rollover in subsection 73(1) of the Income Tax Act.

2. In the 2nd transaction the dentist gifts the same number of shares (500 Non-Voting Common Shares) to the spouse. The spouse receives the gift at the cost base of the dentist – in our example above the cost base to the dentist was nominal/nil and therefore the cost base to the spouse would be nominal or nil. The dentist would not realize any gain on this 2nd transaction pursuant to s. 73(1) of the Income Tax Act.

S. 47 of the Income Tax Act averages the cost bases of all of the spouse’s shares of the same class and therefore the cost base for the 1000 Non-Voting Common Shares will be $800,000.00 (being the $800,000.00 for the 500 Non-Voting Common Shares purchased by the spouse and nominal/nil for the 500 Non-Voting Common Shares that the spouse received by gift).

The spouse then sells the 1000 Non-Voting Common Shares to the purchaser and realizes a capital gain of $800,000.00 (the sale price of $1,600,000.00 minus the spouse’s cost base of $800,000.00. One half of the gain is attributed back to the dentist and taxed in the dentist’s hands and one half would be included in the spouse’s income and offset by the lifetime capital gain exemption of the spouse (in effect the gain would be slightly less as the dentist would also have to sell the dentist’s 1 Voting Common Share). The spouse would then utilize the sale proceeds to pay off the promissory note described above.

The effect is that the dentist and spouse utilized $1,200,000.00 of their capital gains exemption ($800,000.00 by the dentist and $400,000.00 by the spouse) rather than just the dentist’s $800,000.00 capital gain’s exemption resulting in the $200,000.00 being reduced to approximately $100,000.00.

Risks of Adding Spouse as Common Shareholder before Sale

In the recent 2014 tax case, Gervais v. the Queen (2014 TCC64) (a non-dental case but on similar facts as noted above), the taxpayer attempted the above described reorganization and lost in tax court. However, the end result for the taxpayer was that the taxpayer, Gervais, paid the same amount of tax had the taxpayer not entered into any reorganization – the costs of doing the reorganization were the costs incurred for the taxpayers lawyers and accountants. The tax court ruled against the taxpayer based on certain facts that may be applicable only to the facts of the case which facts could possibly be avoided.

Issuing Common Shares to Non-Spouse Family Members

The above scenario does not work with a family member such as a child or parents of the dentist being added as a shareholder immediately prior to the sale.

However, if you add a family member as a non-voting common shareholder on the incorporation or before the value of the DPC appreciates then that family member can enjoy the benefits of the capital gains exemption. Notwithstanding, there are usually very valid reasons why the dentist would not want to add non-spouse family members (even children) as common shareholders, e.g. Family Law Act considerations, estate problems, etc. Usually non-spouse family members are issued non-growth, non-voting shares to enable sprinkling of dividends which can be redeemed for nominal value at any time but do not benefit from the capital gains exemption.

In Summary

There are a number of points that can be learned from the above:

There are very valid reasons to issue Common Shares to a spouse for purposes of enabling the spouse to enjoy his or her capital gains exemption.

It is possible to add a spouse at the last moment before a sale if done properly. However, there are the legal and accounting costs and the risk that Canada Revenue Agency may reassess the dentist and spouse. You must ask yourself whether it is worth it to go through the suggested costs of the reorganization, dealing with Canada Revenue Agency, etc. to save a possible $100,000.00.

The most important lesson is to add your spouse as a shareholder from the initial incorporation of the DPC and avoid having to even think about reorganizing. Even after incorporation it is strongly suggested to add spouses if there is no thought of selling shares of the DPC for many years. If the dentist and spouse are both shareholders from the beginning (or after if there is appreciation in the shares following the date the spouse was added) then the dentist and spouse would, in most cases, be able to enjoy all (if the gain was at least $1,600,000.00) or part (if the gain is less than $1,600,000.00) of their individual $800,000.00 lifetime capital gains exemptions that may be available to them.

It is often not recommended to add non-spouse family members as common shareholders. However, children should be added as special (non-growth) non-voting shareholders for purposes of sprinkling dividends and as common shareholders only in certain circumstances.