Why use a Rollover when Incorporating a Sole Proprietorship

Neufeld Legal PC: Chris@NeufeldLegal.com - 403-400-4092 / 905-616-8864

When incorporating a sole proprietorship in Canada, using a Section 85 Rollover is a crucial tax planning tool that offers significant benefits, primarily tax deferral.

Yet to understand the rationale for utilizing a Section 85 Rollover, it is worthwhile to consider the ramifications of incorporating a sole proprietorship without undertaking a Section 85 Rollover, which includes:

• The business assets of the sole proprietorship will have likely appreciated in value. This includes:

  • Depreciable capital property: Equipment, vehicles, furniture, computers, etc., whose fair market value (FMV) is now higher than their original cost or undepreciated capital cost (UCC).

  • Non-depreciable capital property: Real estate used in the business, intellectual property, patents, trademarks.

  • Eligible capital property: Most importantly, goodwill. This is the intangible value of your business – its brand reputation, customer lists, established relationships, etc. For many successful sole proprietorships, goodwill can be a significant asset with a very low or zero tax cost (Adjusted Cost Base - ACB).

• If you were to simply "sell" these assets at their fair market value to your newly incorporated company without a Section 85 rollover, you would immediately trigger a taxable event on your personal tax return:

  • Capital Gains: For assets like real estate or intellectual property, if their FMV is higher than your ACB, you'd realize a capital gain, of which 50% is taxable.

  • Recapture: For depreciable assets, if the FMV exceeds the UCC, you'd have a recapture of previously claimed depreciation, which is fully taxable as income.

  • Goodwill: This is often the biggest concern. If your sole proprietorship has built up significant goodwill (which often has an ACB of $0 or very little), transferring it at its fair market value would result in a substantial capital gain on your personal tax return, leading to a large immediate tax bill.

The solution to these immediate tax issues is oftentimes a Section 85 Rollover. The Section 85 rollover directly addresses the preceding tax problems by allowing you to transfer these "eligible properties" to your new corporation on a tax-deferred basis. The specific benefits for incorporating a sole proprietorship in conjunction with a Section 85 Rollover include:

• Tax Deferral on Appreciation: Instead of immediately realizing a capital gain or recapture on assets that have increased in value, you and your new corporation jointly elect an "agreed amount" for the transfer. This agreed amount can be set at your tax cost (e.g., ACB for capital property, UCC for depreciable property, or a nominal amount for goodwill if its ACB is low), meaning you effectively defer the gain. The tax liability isn't eliminated; it's simply shifted to the corporation. When the corporation eventually sells those assets, or when you sell the shares of the corporation, the deferred gain will be recognized. This allows you to retain more capital within the business for growth.

• Facilitating Goodwill Transfer: Goodwill is often the most valuable asset of a successful sole proprietorship. Without a Section 85 rollover, transferring goodwill (which usually has a very low ACB for a sole proprietor) at its fair market value to the new corporation would result in a substantial personal capital gain. A Section 85 rollover allows you to transfer this goodwill at an elected amount (e.g., $1 or some other nominal amount), deferring the significant tax hit. The corporation then acquires the goodwill at this elected cost.

• Smooth Transition: It enables a seamless transition of your business operations from a personal structure to a corporate one. You can move all the necessary assets into the corporation without interrupting operations due to immediate tax burdens.

• Flexibility in Consideration: While you must receive at least one share of the new corporation as part of the consideration, you can also receive other forms of consideration, such as a promissory note (often called "boot"). This can be useful for withdrawing funds from the corporation in the future without additional tax if structured correctly (though careful planning is needed to avoid immediate tax triggers if the boot exceeds the tax cost of the assets).

• Setting up for Future Tax Planning: Once the assets are in the corporation, you can take advantage of corporate tax rates (which are often lower than personal rates for active business income in Canada). It also sets the stage for future tax planning strategies, such as: Income Splitting: Potentially splitting corporate income with family members through dividends or salaries (subject to "tax on split income" rules, where applicable).

• Estate Freezes: Locking in the value of your shares for estate planning purposes, allowing future growth to accrue to other family members (e.g., children or a family trust).

• Lifetime Capital Gains Exemption (LCGE): If your shares qualify as "Qualified Small Business Corporation Shares" (QSBCS) in the future, you may be able to use your LCGE upon their sale. Sometimes, a "capital gains crystallization" may be done in conjunction with a Section 85 to trigger a capital gain and immediately use the LCGE.

In summary, using a Section 85 rollover when incorporating a sole proprietorship is almost always recommended to avoid a potentially large and immediate personal tax bill on the appreciation of your business assets, particularly goodwill. It allows for a tax-efficient transfer, preserving capital and setting the stage for future corporate tax planning benefits.

As with any tax planning / structuring strategy, there are numerous considerations of great significance that will need to be address, and be impacted by the specific facts and circumstances, including but not limited to:

Eligible Property: Not all assets qualify for a Section 85 rollover. Generally, it applies to capital property (depreciable and non-depreciable), eligible capital property (like goodwill), and certain types of inventory. Cash and prepaid expenses generally do not qualify.

Taxable Canadian Corporation: The transferee must be a taxable Canadian corporation.

Consideration: The transferor must receive at least one share of the transferee corporation as part of the consideration. If non-share consideration (like a promissory note or cash, often referred to as "boot") is received, it can trigger immediate tax consequences if it exceeds certain limits.

Joint Election: The transferor and the corporation must jointly elect for the Section 85 rollover by filing a prescribed form (Form T2057 for individuals/trusts/corporations, or T2058 for partnerships) with the Canada Revenue Agency (CRA). This election must be filed by a specific deadline.

Significance of Professional Advice: Section 85 rollovers are complex and involve strict rules. It is highly recommended to seek advice from a tax accountant and a lawyer to ensure compliance and to properly structure the transaction for your specific circumstances..

For knowledgeable and experienced tax law representation for corporate tax rollovers and other tax planning strategies, contact tax lawyer Christopher R. Neufeld at Chris@NeufeldLegal.com or call 403-400-4092 (Calgary, Alberta) / 905-616-8864 (Toronto, Ontario).

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