Paying tax for selling your sole-proprietorship business to yourself! Use Section 85 rollover to eliminate that tax!
Section 85 Rollover; If you have been operating a sole-proprietorship business and are now incorporating; make sure you elect under the Section 85 rollover to avoid personal capital gains tax. In this blog, we will provide you details on its benefits and the process involved.
What is a Section 85 roll-over?
Electing under Section 85 rollover of the income tax act entitles you to transfer assets or shares of a Canadian entity (I.e Corporation, sole-proprietorship, or partnership) into another Canadian entity tax-free. Imagine paying tax for selling your own business to yourself! Luckily, for this election you can avoid it through strategic tax-planning.
Let’s take a simple example, Bob has a sole-proprietorship business that is consulting based; as a result, the main asset is goodwill of his clients. The estimated fair market value of the business is $100,000 and the cost for setting up the business was $5,000. If Bob does not elect under Section 85 upon transferring the business into a corporation; he will incur a personal capital gain of $100,000 minus the adjusted cost base (ACB) of $5,000, totaling $95,000. 50% of this amount is taxable for income tax purposes.
By electing under Section 85 rollover, Bob can transfer the business into the corporation for $100,000. In consideration for this asset, the corporation must issue a combination of shares and cash-value equaling the fair market value of the business; i.e 95,000 Special shares that Bob can redeem later on and a notes payable of $5,000.
It is important to understand the corporation must always give consideration equaling the fair market value for the asset(s) being transferred into the corporation. There are complex rules on how much cash-value and shares can be issued for which you should consult with a tax accountant.
Determine the value of your Sole-proprietorship Business
An important step of the Section 85 rollover is to calculate the fair market value of your business. For a medium-large business or complex structures, a professional valuator such as a CBV should be used. A simple business may use online calculators or take averages of net income for the past few years and use a multiplier based on the industry. A good way to start is to ask yourself how much you would sell the sole-proprietorship business to a third-party for.
It is also important for each company asset you determine its fair market value and if it has been depreciated for tax-purposes, the undepreciated capital cost (UCC) remaining. A tax-accountant will help you with this calculation as it can be complex and there are tax-rules for certain assets such as Goodwill and Accounts Receivable.
Incorporate your company
In order for you to establish a separate entity, you will need the corporation’s articles of incorporation registered. You can read more about incorporating a company in Ontario by reading our blog:
It is important a tax-accountant review the share classes and share clauses; Section 85 has specific clauses required to be in compliance.
Preparation of the Section 85 Rollover Agreement
Your tax-accountant will prepare the section 85 rollover agreement which will be between the sole-proprietor business and corporation. It will detail the consideration being received, assets fair market value/UCC etc. It is important it contains a price adjustment clause in case the CRA reassess the fair market value to be less or more. As long as the price adjustment clause is present, you will still not incur a capital gains tax even if the CRA revises the values.
Preparation of the T2057 Form
This CRA form will be submitted to the CRA containing details from the agreement and many other tax-related details. It is important a professional tax accountant prepares this form; this will ensure it is in compliance with the CRA and Section 85 rollover rules.
The Section 85 rollover election due date is the earliest date of the transferor or transferee’s due date to file a regular tax return for the tax year in which the transaction took place.
The penalties and interest for this election can be material if not filed on a timely basis.
This election is very strategic to help minimize your taxes and should always be used when converting a sole-proprietorship business into a corporation. It is important you always consult with a tax-accountant when using this election due to its complexity.
The information provided on this page is intended to provide general information. You should consult with a tax professional to full determine the scope of your situation, Gurrai Birdi and Birdi Chartered Professional Accountant shall not be held liable from usage of the information provided on this page.
Author: Gurrai Birdi, CPA, CGA, MBA
Gurrai Birdi is a Chartered Professional Accountant (CPA, CGA, MBA) who has years of extensive experience in public practice working with highly satisfied individual and business clients to ensure there taxes are minimized and accounting needs are fulfilled.