Suppose you have been running a business as a sole proprietor – that is, on your own with all the debts being your responsibility in your personal capacity. You have accumulated some valuable assets such as equipment, cash from revenues and goodwill. As your business grows, you decide you want to incorporate the business to benefit from certain tax advantages while also limiting your exposure to personal liability.
In the process of incorporating, you would be transferring these business assets to this newly incorporated entity, your corporation. Such a transfer may be considered a “disposition” or “sale” by the Canada Revenue Agency (CRA) and thus, may leave you susceptible to paying capital gains tax on the assets. For instance, if you built up your goodwill (e.g., your client list) of the business from scratch ($0.00) and can now value such an asset at $50K, when you transfer it to your corporation, you will have realized a capital gain of $50K, a gain for which capital gains tax will apply. In order to defer this tax consequence, you could perform a section 85 rollover.
Section 85 of the Income Tax Act allows for a joint election to be made by the business owner and his or her new corporation. The way the rollover works is that the individual business owner agrees to transfer the business assets to the corporation in exchange for common shares of the corporation. Following this type of exchange and the filing of the required CRA forms, the rollover is complete and no capital gains tax would be payable by the business owner on the transferred assets. The corporation is now the owner of the assets and – as the sole director, officer and shareholder – the business owner is able to operate the business in the same way as he or she did previously as a sole proprietor.
However, in order to properly perform this section 85 rollover, you must ensure that the value of the assets being transferred to the corporation is equal to the value of the amount received in exchange. If the amount received is overvalued, then the elected amount will be deemed by the CRA to be the fair market value of the transferred property. In other words, you must sell the business assets to the corporation at fair market value, a value which your accountant can help you determine.
It should be noted that this tax rollover does not amount to tax avoidance, but rather tax deferral. Any appreciation in the value of the transferred assets not taxed at the time of the rollover (i.e., the deferred gain) will eventually be taxed at the time the assets or sold or otherwise disposed of by the corporation. The business owner may also be taxed on the deferred gain when he or she disposes of the shares he or she received by the corporation in exchange during the rollover.
Although the CRA does not usually target unincorporated small businesses when they make the transition to incorporation, utilizing this section 85 rollover acts as a good insurance policy to protect a business owner from a CRA assessment on the owner’s goodwill or other transferred assets.
You should always consult your corporate lawyer and accountant if you are thinking of performing a section 85 rollover, as there are numerous requirements and considerations that need to be carefully followed. Such professionals will also help you evaluate whether your particular business can benefit from such a transaction.