By Nizam Shajani, CPA, CA, MBA, Partner
Tax free rollovers should be considered when property is being transferred to a corporation. This plan may be useful when moving from a proprietorship to a corporation or where a shareholder has something of value that would be beneficial to use in the corporation. The plan also allows for opportunities to extract funds from a corporation tax free.
By incorporating, the business may take advantage of tax planning opportunities and advanced business arrangements as well as the lower small business deduction and corporate tax rates. However when transferring assets into the corporation, deemed disposition rules may result in a taxable event. Using a roll over plan (under section 85) will allow assets that have appreciated in value to transfer into the corporation at cost so that there is no immediate tax consequence.
When property is transferred from one entity to another, such as from an individual to a corporation – the entity that transferred the property may be deemed to have disposed of that property at fair market value. For instance, suppose an individual stated a business as a sole proprietor. Over time that business has increased in value and now worth $100,000. With the growth, the individual has decided to incorporate the business and continue to operate as the corporation. The transfer of the client list and assets into the corporation would be considered a deemed disposition at fair market value and result in a taxable capital gain of $100,000. To alleviate this tax burden, a roll over (under section 85) should be used.
To claim the roll over, an election should be filed with CRA to detail the amount being transacted at. This can be between the taxpayer’s cost and the fair market value of the assets being transferred, however may not be less than the actual amount paid for those assets by the corporation.
The roll over can also be used to move assets into the corporation and extract tax free funds. Considering the transaction may be done anywhere between the cost basis and fair market value – where an individual was to transfer say real estate with a cost basis of $100,000 and a fair market value of $250,000 – the property can be transferred at $100,000 – resulting in either a share holder loan or paid up capital (the cost basis of shares given to the individual in exchange for the real estate). This loan or paid up capital can then be repaid tax with corporate profits without incurring any additional personal tax using the roll over.
The individual may also choose to transact at a value higher than their cost basis (and no more than the fair market value) and incur some tax at the lower capital gains rate. For instance if an individual normally takes funds from their corporation as a salary of $150,000 annually – they may choose to transfer the property at $250,000 and incur a capital gain of $150,000 ($250,000 elected amount less their cost basis of $100,000). Rather than take a salary in that year the individual may repay $150,000 of the shareholder loan in the first year and pay capital gains tax at half their regular rate and the remainder of the loan may be paid in the second year as the balance of the shareholder loan and taken tax free.
Property that is rolled over on this tax deferred plan should be eligible for a roll over. Eligible property generally includes inventory, depreciable and non-depreciable capital property, goodwill and resource property. Exclusions from eligible property are cash, accounts receivable, prepaid expenses, real property, land inventory and future tax assets.
This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action.