What is a management buyout? A management buyout is where an employee or group of employees of a business buys the business from their employer who is also the owner of the business. This video discusses the three most common ways that a management buyout is carried-out.
Buy Shares – Management Buyout and Taxes in Canada
The most common way to implement a management buy in Canada is for the employee or group of employees to buy the shares from the owner of the business.
The major advantage of this strategy is that the owner can claim the capital gains exemption on the sale of his shares. This means that the owner can receive up to $750,000 of profit on the sale of his shares without paying any tax whatsoever.
The major disadvantage of purchasing shares is that the employee or group of employees may not have sufficient cash or the financing available to purchase the owner’s shares.
Additionally, the employment income that the employees receive may not be sufficient to buy the shares directly from the owner, because of the high rate of tax levied on employment income. For example, in the province of Ontario the highest marginal tax rate is 46.4%.
Repurchase the Shares from Owner – Management Buyout and Taxes in Canada
The second way that a management buyout can take place is by having the corporation directly repurchase the shares from the owner. If the corporation has sufficient cash on hand, then the corporation can buy all of the shares at once. Otherwise, the corporation an repurchases the owner’s shares over a period of time.
In this management buyout strategy, the employees of the company agree to lower their salaries, in order to provide the company with sufficient cash to buy the shares from the existing owner.
The cash paid from the corporation to the owner on the repurchase of his shares is treated as a taxable dividend to the owner. Once the shares are repurchased, new shares for a nominal amount are issued to the employees.
Create Newly Formed Corporation – Management Buyout and Taxes in Canada
The third and final way to implement a management buyout is to have the owner sell his shares to a newly formed corporation, which is owned by the employees.
The management buy-out is accomplished in three steps. Let’s take the example of ABC Corporation, which is presently owned by Mr. X. Mr. X wishes to sell his corporation. The employees have formed a new corporation, called Newco.
- Step 1: Newco acquires the shares of ABC Corporation from Mr. X in exchange for a promissory note payable to Mr. X. The amount of the promissory note payable is equal to the fair market value of the shares at the date of the sale.
- Step 2: ABC Corporation pays a dividend from its cash-on-hand to Newco. Newco is not required to pay tax on the dividend received.
- Step 3: Newco uses the cash received from the dividend to repay the promissory note payable to Mr. X.
Both parties, Mr. X and the employees, win in this example. Mr. X does not have to pay any tax whatsoever on the first $750,000 of profit on the sale of his shares by claiming the capital gains exemptions. Furthermore, the employees were able to use the profits of ABC Corporation to repay the owner.
Contrast this to the previous management buy-out strategy, where employees had to use the after tax cash from their salaries to purchase the shares directly from the owner, which is not tax-efficient.
The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.