The Impact of New Capital Gains Tax Rules on Small Business Owners

Many small business owners are likely to feel intense frustration once they grasp the implications of the new capital gains tax rules in both Canada and the United States. Both federal administrations are planning to increase capital gains taxes by year-end, if not sooner.

While this tax increase will apply across the board to capital gains, this column specifically examines its effect on small business owners who are contemplating selling their shares as part of their retirement exit strategy.

Let’s begin by examining the impact on U.S. business owners.

In very simplified terms, consider a scenario where a business owner sells small business shares for $100,000, and the original cost of those shares was, for example, $1.00. Under existing rules, the capital gains tax on this sale would be approximately $20,000.

However, under the proposed rules, the overall tax burden could soar to as much as 44%. Here’s how it breaks down:

• The net investment income tax (NIIT) would rise from 3.8% to 5%.
• The new capital gains tax rate would be 39%.
• When combined, these two taxes result in a total tax rate of 44.6%.

As a consequence of these changes, the tax bill for the sale of the aforementioned shares would now be $44,600, significantly higher than the initial $20,000 estimate.

Canada’s Perspective: Tax Changes and Surprises

Interestingly, Canada’s new proposal for a similar scenario is now estimated to be approximately $30,511, up from the previous $23,000. This shift challenges the common perception that taxes are inherently higher in Canada.

Why is this such a sore spot for retiring business owners? First, they often face tough negotiations with private buyers who, at best, offer three times the net earnings for their shares. Then, as they exit the business, the tax department further compounds their financial burden.

Depending on the size of the sale, some business owners may find themselves adding a couple of zeros to the tax bills they anticipated.

Is there a workaround? Absolutely. Rather than selling the shares outright, consider creating a savvy alternative strategy for generating income and preserving legacy capital.