Sole Proprietor Rollover into a Corporation
As a business operating as a sole proprietor finds success – the benefits of a sole proprietorship may be outlived and a conversion to a corporation should be considered. However, the tax impact of this transfer must be planned for. The conversion from a sole proprietor to a corporation is a taxable event. However, done correctly – you may be able to defer all the gain.
Once a sole proprietor decides to form a corporation, it is usually desirable to transfer ownership of all the business assets from the proprietor to the newly formed taxable Canadian corporation. It is important to understand that the corporation and the individual are two separate entities for tax purposes. As such, a transfer of assets from the individual sole proprietor to the corporation would be deemed to be a sale at fair market value – and result in a taxable event. However, provisions within section 85 of the tax act allow for the assets to be rolled over at the proprietors cost base and this must be reported properly.
Physical assets such as computers, vehicles, furniture etc. may be transferred into the corporation as well as intangible assets such as goodwill. The goodwill of a business may include customer lists, trade names and other intangibles that add value to the business. You will need to consider what the business would sell for to a third party and subtract that amount from the value of the tangible (physical) assets of the business to come up with an estimated goodwill value. An accountant should be able to help you with this valuation – and documentation would be warranted.
The transfer of assets can be accomplished without triggering a gain or loss on disposition by taking advantage of the section 85 rollover provisions allowed for Canadian income tax purposes. The application of the rollover provisions can involve complex tax elections and accounting and legal considerations and such transactions should not be undertaken without professional advice.
When the tax election is made, both the proprietor and the corporation select proceeds of disposition of assets as the “agreed amount” so as to avoid the payment of any immediate tax. In its simplest form, the purchaser corporation assumes the tax position of the proprietor with the respect to the property in exchange for consideration that includes the issuance of shares in the corporation to the proprietor with a tax cost equal to the tax cost of the assets transferred.
The rollover provisions apply to “eligible property” that includes capital property (real estate, shares, partnership interest etc.), inventory (excluding real property inventory), eligible capital property (goodwill), and Canadian resource property. Assets not considered to be “eligible property” include accounts receivable, prepaid expenses, and life insurance policies.
For those assets that are eligible for rollover treatment there is the potential to inadvertently produce unexpected taxing events. For example, benefits could be conferred on another shareholder besides the transferor where the Fair Market Value (FMV) of the property transferred to the corporation exceeds the FMV of property received as consideration from the corporation. Also, because a rollover requires determination of the FMV of property transferred and consideration received, it is important to make a reasonable estimate of FMV and ensure that the rollover agreement contains a price adjustment clause in the event a governing authority questions the valuation chosen. The absence of such a clause can trigger adverse tax consequences.
A rollover election requires an allocation of the tax cost of consideration received that is equal to the agreed amount. Generally, an allocation must be made first to any non-share consideration received next to preferred shares and finally to any common shares issued.
It should be noted that a risk of filing a rollover is the potential for double taxation. If the eligible property is disposed of by the corporation a capital gain could be realized and subject to tax in the corporation. Following the disposition, if the shareholder were to die, the shares are deemed to be disposed of at FMV which could also trigger a similar gain that would be subject to tax in the estate.
There are potential GST implications that are triggered on the non-arm’s length transfer of property to a corporation. The transferor will be liable to charge and collect GST from the corporation based upon the FMV of the property transferred. However, the corporation will be entitled to claim an equivalent Input Tax Credit (ITC) for the amount paid.
It is also important to consider provincial tax implications. In Alberta it is possible for the “agreed amount” to be other than the amount elected for federal purposes. This is necessary in light of the differing amounts of capital cost allowance that might have been deducted for provincial and federal purposes.
Administrative processes should also be followed in closing a sole proprietor. This includes canceling your business registration number with registries along with the cancelation of any business numbers registered with CRA for GST/HST, and payroll. New registration will need to be made in in the corporate name for a CRA business number, along with any registerable assets such as a vehicle.
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. © 2021 Shajani LLP.
Shajani LLP is a CPA Calgary, Edmonton and Red Deer firm and provides Accountant, Bookkeeping, Tax Advice and Tax Planning services