Transferring Assets to a Taxable Canadian Corporation
Section 85 Rollover
So you have a very successful unincorporated proprietorship business and want to incorporate for credit protection and to take advantage of the reduced corporate income tax rates for a Canadian Controlled Private Corporation. One of the most commonly used tax planning methods is a Sec 85 Rollover which permits eligible individual taxpayers to elect jointly with the corporation on the transfer of property from the taxpayer to the corporation.
The Sec 85 Rollover provisions allows a taxpayer (an individual, corporation, partnership or trust) to transfer eligible property to a Canadian corporation without triggering any income or capital gains. This is especially useful in circumstances where the property transferred has increased in value from its cost to the taxpayer. Sec 85 Rollover provisions do not eliminate the capital gain as a result of the transfer. It only allows the deferral of the income taxes payable on the capital gains.
Eligible property includes capital property, depreciable property, inventory, and internally generated goodwill. Real property that is inventory to the taxpayer is not eligible to the Sec 85 Rollover provisions, ie. Land properties owned by a home builder.
The transferor/taxpayer must take back share consideration. Non-share consideration (cash, notes payable etc) can also be taken by the taxpayer. The T2057 form filed with CRA jointly elects and specifies the elected amounts. All transfers must be conducted at Fair Market Values (“FMV”). If not, there will be negative tax consequences. Depending on the value of property being transferred and the value of the internally generated Goodwill, a valuation from a Certified Business Valuator may be required to support the agreed amounts determined in the Sec 85 Rollover Election. If for example, the assets, including goodwill, are valued at $1million, then you must take back total consideration of $1million. If you elect more value from the corporation than you put in, you will have a shareholder benefit resulting in a deemed taxable dividend. Conversely, if you put more value into the corporation than you take out in order to benefit a related person, the elected amount will be increased by the amount of the benefit which will lead to a taxable capital gain.
The transferor should have a purchase/sale agreement prepared that includes a price adjustment clause as part of the Sec 85 Rollover. The price adjustment clause allows for more or less, share to be issued in the transaction, if the CRA disagrees with the taxpayer’s assessment of” FMV”, to make sure the transaction is conducted at fair market value.
Non-share consideration, called boot, can include cash, other assets, and assumed debt such as a note to the transferor. If the seller takes boot, they should not take more than the tax cost of the assets being transferred ie. Adjusted cost for non-depreciable property and undepreciated capita cost of depreciable property. Taking too much non-share consideration results to the elected amount being automatically increased which results to a capita gain.
Following our previous example:
Land Asset Tax Cost $100,000
Fair Market Value $ 1 million
Using Sec 85 Rollover provisions, the taxpayer can receive non-share consideration up to $100,000 without triggering capital gains. In the above example, they would elect $100,000 none-share consideration in the form of a note payable to them and $900,000 in preferred share consideration, totalling the fair market value of $1 Million. This would result in the deferral of any income tax payable on the transfer.
Conversely, let’s assume that the taxpayer has net capital losses of $50,000 that are being carried forward on his personal income taxes. Since they can make the elected value anywhere between tax cost and fair market value, in this case $100,000 tax cost and $1 Million fair market value, they can elect $200,000 in non-share consideration without any taxes payable. The $200,000 elected amount would trigger a $100,000 capital gain to the taxpayer, 50% of which or $50,000 is taxable. The taxpayer will not pay any taxes because he will utilize the net capital losses of $50,000 to offset the capital gain generated by the transfer.
As noted above, the elected amount can be anywhere from tax cost to Fair Market Value. It cannot be less than the tax cost of the asset being transferred or more than the Fair Market Value of the assets being transferred.
The elected amount determines four things for tax purposes:
- The proceeds of the disposition to the seller
- The tax cost to the purchaser
- The tax cost of the consideration taken back by the seller
- The paid-up capital of the share consideration
The most common error made in the filing of the Sec 85 Rollover election form is that internally generated goodwill is not included. This is why it is important to have a business valuation prepared that includes all assets, including goodwill.
Tax Planning Opportunities
A Sec 85 Rollover is most useful in the following situations:
- Selling your business
If you are selling your unincorporated business you may want to use the Sec 85 Rollover provisions in order to access the Lifetime Capital Gains Exemption, 2021 $892,218, by selling the shares in your corporation.
- Family Business Planning
If your family members are active in your unincorporated business you may wish to utilize Sec 85 Rollover provisions to allow them to participate in the future growth of the company.
This course material deals with complex matters and may not apply to particular facts and circumstances. As well, the course material and the references contained therein reflect laws and practices which are subject to change. For these reasons, the course material should not be relied upon as a substitute for specialized professional advice in connection with any particular matter. Although the course material has been carefully prepared, neither the author, and/or firm, nor any persons involved in the preparation and/or instruction of the material accepts any legal responsibility for its contents or for any consequences arising from its use.