Selling your business: how to qualify for the $1.25 million lifetime capital gains exemption

The lifetime capital gains exemption is decided in the two years before you sell, not at the closing table. As at the time of writing it shelters up to $1.25 million of capital gain per individual on qualified small business corporation shares. The claims we see fail rarely fail on the deal itself. They fail because the corporation carried too much cash or investments through the prior 24 months, because the shares were issued too recently, or because an old investment loss quietly reduced the room.

What the exemption is worth and who can use it

The $1.25 million limit applies to dispositions on or after June 25, 2024, and is indexed from 2026, so confirm the current figure with the CRA. It is cumulative over your lifetime, so earlier claims reduce what remains. It is available only to individuals resident in Canada, only on qualified small business corporation shares or qualified farm or fishing property, and never on a sale of assets by a sole proprietor or a corporation. The inclusion rate remains one-half at the time of writing, the proposed increase having been cancelled; see what the inclusion rate change means for business owners. The claim is made on Form T657 with Schedule 3 of your personal return, and the essentials are in what the lifetime capital gains exemption is and how to qualify.

Illustrative example: a founder sells her shares for $1.6 million with an adjusted cost base near zero. With the exemption, $1.25 million of the gain is sheltered and the remaining $350,000 produces $175,000 of taxable income, which at Ontario's top personal rate costs in the region of $94,000 before any alternative minimum tax. Without it, $800,000 of taxable income would cost roughly $428,000 at that rate.

The three QSBC tests your shares must pass

Test one: 90% active at the moment of sale

At the time of sale, all or substantially all of the fair market value of the corporation's assets must be used principally in an active business carried on primarily in Canada. The CRA reads "all or substantially all" as 90% or more. Cash beyond working capital needs, an investment portfolio, a rental property, a loan to a shareholder and the cash surrender value of corporate-owned life insurance all count against you.

Test two: more than 50% active throughout the prior 24 months

For the full 24 months before the sale, more than 50% of the fair market value of the assets must have been used in the active business. This is the test that catches profitable companies that let cash build up for years, and it cannot be fixed the week before closing. Where a holding company sits between you and the operating company, the rules apply across both and one of them must meet a stricter 90% standard through the period.

Test three: nobody unrelated owned the shares in the last 24 months

Throughout those 24 months the shares must not have been owned by anyone other than you or a person related to you. Shares issued to you from treasury in exchange for the assets of a business you already ran, typically under a section 85 rollover, can qualify without waiting out the period if those assets would themselves have passed the tests. Shares issued for cash, or bought from an unrelated shareholder, generally start a fresh 24-month clock.

Purification: getting the corporation clean and keeping it clean

Purification is the removal of passive assets so the corporation passes the tests. In rough order of simplicity:

• Pay down debt with surplus cash, which shrinks the balance sheet without touching the active assets.
• Pay taxable dividends or bonuses to take the surplus out, accepting personal tax now for the exemption later.
• Buy active assets you genuinely need, such as equipment or a building used in the business.
• Move passive assets to a holding company on a tax-deferred basis, using a section 85 transfer and an intercorporate dividend or a related-party reorganisation.
• Collect shareholder loans and clear CRA balances before a buyer finds them.

Two cautions. An intercorporate dividend that exceeds the payer's safe income can be recharacterised as a capital gain under subsection 55(2) when one of its purposes is to reduce the gain on a share sale, so the holding company route needs a safe income calculation first. And purification has to be maintained: passing the 50% test means sweeping surplus out at least annually for two years, then a final sweep just before closing for the 90% test. Whether a holding company suits you is covered in should I set up a holding company and holding company pros and cons.

Share sale or asset sale: the negotiation with your buyer

The exemption applies only to a sale of shares, and buyers usually prefer assets. In an asset sale your corporation pays tax on recapture and on the gain, half of the gain is credited to the capital dividend account and can be paid to you tax-free, and the rest comes out as taxable dividends, which usually leaves less in your hands than an exempt share sale.

The gap is negotiable. Buyers routinely accept a share deal in exchange for a lower price, representations and warranties backed by an escrow or holdback, or a hybrid in which part of the value moves as assets. Knowing how much of the difference is worth conceding starts with how to value a small business.

Multiplying the exemption across the family, and passing it to the next generation

One exemption per shareholder

Each individual who owns qualifying shares can claim their own exemption on the gain attributable to those shares. A spouse and adult children who hold shares directly, or through a discretionary family trust, can each shelter up to the limit. The usual route is an estate freeze: you exchange your common shares for fixed-value preferred shares, the trust subscribes for new common shares for a nominal amount, and growth from that day accrues to the trust. The trust must hold the shares for 24 months, and gains it allocates to beneficiaries keep their character through the designations on the trust return.

Attribution and the tax on split income

Gains on shares you gave to your spouse are attributed back to you unless the spouse paid full value from their own funds. For an adult family member, a gain on qualifying small business shares is excluded from the tax on split income, so the exemption can be claimed without the hours-worked or ownership tests that govern dividends. For a child under 18, a sale to a buyer who is not at arm's length is recharacterised as a dividend taxed at the top rate, which removes the exemption, so plans involving minors need specific advice. The dividend rules are in can I pay my spouse dividends from my corporation, and any multi-shareholder structure needs a shareholders' agreement in place first.

Selling to your children

A sale of shares to a corporation owned by your child is normally caught by section 84.1, which converts the gain into a deemed dividend and removes the exemption. Since January 1, 2024, a genuine intergenerational transfer can keep capital gains treatment under either an immediate transfer, with conditions tested over about three years, or a gradual transfer, tested over five to ten years. The conditions cover giving up control, handing over management, the children's continued involvement and a joint election. A capital gains reserve of up to ten years is available on these transfers, against five years otherwise. The detail is in handing a family business to the next generation tax-efficiently and our guide to succession planning for Canadian small businesses.

Three traps that shrink the claim: AMT, CNIL and past business investment losses

Alternative minimum tax

Since the 2024 changes the alternative minimum tax applies a 20.5% rate above a basic exemption of roughly $175,000 to $180,000 depending on the year, and capital gains sheltered by the exemption enter the AMT base at 30%. On a $1.25 million exempt gain that can mean a six-figure minimum tax in the year of sale even though regular tax is small. The AMT is recoverable against regular tax over the following seven years, but only if you have enough regular tax to absorb it, which a retiring owner often does not. Model it before closing and confirm the current exemption amount with the CRA.

Cumulative net investment loss

Your CNIL is the running total since 1988 of investment expenses such as interest on money borrowed to invest, carrying charges and rental losses, less investment income. A positive balance reduces the exemption you can claim until it is cleared, and the fix is to receive enough taxable dividends or interest in the years before the sale to bring it to zero.

Allowable business investment losses

An allowable business investment loss claimed in an earlier year, for example on a failed investment in another private company, also reduces the exemption available. We recompute the remaining room from prior returns before any sale.

The timeline: start at least 24 months out

1. 24 to 36 months before: test the shares against all three QSBC conditions, price the purification options, decide whether a freeze and trust suit your family, and start clearing any CNIL balance.
2. 12 to 24 months before: produce three years of clean financial statements, normalise owner compensation and one-off costs, obtain a valuation, and keep instalments and HST current.
3. 6 to 12 months before: assemble the data room, engage the deal team, and settle the structure: share versus asset, earn-out or vendor take-back and the working capital target.
4. At closing: run the final purification sweep for the 90% test, confirm the price allocation, and decide whether to claim a reserve on proceeds not yet received.
5. The following spring: file Form T657 with the return, account for AMT and, where a trust is involved, complete the allocations on the trust return.

Our business advisory and fractional CFO service runs this timeline with you, from the first QSBC review to the closing sweep.

Sources: CRA — Line 25400 Capital gains deduction · CRA — Form T657.