Navigating the Transition: How to Roll Your Sole Proprietorship into a Corporation Tax-Free in Canada

In the ever-evolving landscape of Canadian business, the transition from a sole proprietorship to a corporation stands out as a pivotal moment, offering a gateway to enhanced growth, sustainability, and efficiency. At the heart of this transformative journey is the strategic utilization of tax planning mechanisms, specifically the provisions outlined in Section 85 of the Income Tax Act (ITA). This powerful tool, when navigated with precision and expertise, can significantly mitigate tax implications, streamline business restructuring, and align your enterprise’s evolution with your long-term ambitions.

As a seasoned tax expert with a comprehensive background in Chartered Professional Accountancy (CPA, CA), Master in Tax Law (LL.M (Tax)), Master in Business Administration (MBA), and Trust Estate Practitioner (TEP) designations, my mission is to guide family-owned enterprises through the complexities of tax planning and corporate transitions. The essence of our approach is captured in our tagline, ‘Tell us your ambitions, and we will guide you there.’ This commitment underpins our dedication to not only ensuring compliance and optimizing tax strategies but also supporting the growth and success of your business.

The journey of transitioning your business structure is fraught with complexities, from identifying eligible property and navigating the consideration for transfer to executing the rollover process effectively under Section 85. Each step presents unique challenges and opportunities, requiring a nuanced understanding of tax law and a strategic approach to financial planning. However, the rewards of this transition—tax efficiency, enhanced business growth, and the realization of your entrepreneurial vision—make it a worthwhile endeavor.

This introduction sets the stage for a comprehensive exploration of how strategic tax planning, particularly through the application of Section 85, can facilitate a smooth transition from a sole proprietorship to a corporation. By delving into the specifics of eligible property, the nature of consideration for transfer, and providing illustrative case studies, we aim to demystify the process and highlight the critical role of professional guidance in navigating these waters.

Embracing the complexities of tax law and leveraging it to your advantage is not just about achieving compliance; it’s about setting the foundation for the future success of your business. Let us guide you through this journey, aligning our expertise with your ambitions, to ensure that your transition not only meets legal requirements but also positions your enterprise for long-term growth and success.

Understanding the Basics: Section 85 of the ITA

Navigating the complexities of tax law is a daunting task for many business owners, yet understanding these nuances is crucial for those looking to transition from a sole proprietorship to a corporation in Canada. At the heart of this process is Section 85 of the Income Tax Act (ITA), a provision that offers a tax-efficient pathway for business owners to roll their operations into a corporation. This segment aims to demystify Section 85, providing a comprehensive guide for entrepreneurs looking to leverage this provision to their advantage.

The Purpose of Section 85

Section 85 of the ITA is designed with a clear purpose: to facilitate the transfer of business assets from an individual or a partnership to a Canadian corporation without triggering immediate tax implications. This provision recognizes the continuity of business despite a change in the legal structure and offers a mechanism to defer the recognition of any gains or losses associated with the transfer of eligible property. The intent is to encourage business growth and restructuring by removing tax barriers that might otherwise deter sole proprietors from incorporating.

Eligible Property: What Can Be Transferred?

Understanding what constitutes “eligible property” is fundamental to leveraging Section 85 effectively. The ITA defines eligible property to include capital property, inventory, and certain other assets that the business uses in its operations. Capital property could be tangible assets like equipment and buildings or intangible assets such as patents and trademarks. However, not all assets qualify; specific exclusions apply, such as real property owned by non-residents. Determining which assets are eligible requires careful consideration of both the nature of the assets and the business’s circumstances.

The Consideration: Shares as a Mandatory Component

A pivotal aspect of a Section 85 rollover is the consideration received in exchange for the transferred assets. The ITA mandates that this consideration must include shares of the corporation receiving the assets. This requirement ensures that the transferring party retains an equity stake in the corporation, aligning their interests with the success of the newly formed corporate entity. The value and class of shares issued can vary, offering flexibility in structuring the transaction to meet the strategic goals and financial needs of the business.

The Joint Election: A Crucial Step

For a transfer under Section 85 to be recognized by the Canada Revenue Agency (CRA), both the individual (or partnership) transferring the assets and the corporation receiving them must jointly elect to have the provisions of Section 85 apply. This is accomplished by completing and filing Form T2057, Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation. The timing of this election is critical; it must be filed by the earliest tax filing deadline of any of the parties involved for the year in which the transfer occurs. This joint election not only signifies consent from both parties but also specifies the agreed-upon values of the transferred assets.

Agreed Amount: Navigating Valuations

A cornerstone of the Section 85 election is the negotiation of an “agreed amount” for the transferred assets. This amount serves as the proceeds of disposition for the transferor and the cost basis for the corporation. The agreed amount must reflect a balance between not exceeding the fair market value (FMV) of the assets and not falling below certain thresholds, such as the adjusted cost base (ACB) for non-depreciable property or the undepreciated capital cost (UCC) for depreciable property. Striking this balance is crucial for maximizing tax deferral while complying with the ITA.

Tax Deferral: The Heart of Section 85

The essence of Section 85 lies in its ability to defer tax on the transfer of business assets. By electing under this section, the immediate tax consequences of the disposition are postponed. Instead of recognizing a gain or loss at the time of transfer, the tax implications are deferred until a future event—such as the sale of the transferred assets by the corporation or the disposition of the received shares by the transferor. This deferral mechanism allows for the seamless transition of assets into a corporate structure without the burden of immediate tax liabilities.

Professional Guidance: Navigating Complexity

The intricacies of Section 85, from determining the eligibility of assets to structuring the transfer and negotiating the agreed amount, underscore the importance of professional advice. Tax laws are nuanced, and the stakes are high; missteps can lead to unintended tax consequences or missed opportunities for optimization. Engaging a tax professional with expertise in corporate transitions can provide invaluable guidance, ensuring that the election is made correctly and that the strategic goals of the business are met.

Section 85 of the Income Tax Act offers a powerful tool for business owners seeking to incorporate their operations. By understanding and navigating the requirements of this provision, entrepreneurs can achieve a tax-efficient transition, laying a strong foundation for future growth. With careful planning and expert advice, the complexities of tax law can be transformed into strategic opportunities, enabling businesses to thrive in their new corporate form.

Eligible Property and the Consideration for Transfer: Navigating Section 85

When considering the transition from a sole proprietorship to a corporation under Canada’s Income Tax Act (ITA), understanding the nuances of eligible property and the nature of the consideration for transfer is paramount. This section of the rollover process, governed by Section 85, is critical in ensuring that the transfer not only meets legal requirements but also aligns with the strategic financial goals of your business. Here, we delve into the specifics of what properties qualify, the requisite form of consideration, and the key steps and considerations involved in executing a successful transfer.

Defining Eligible Property

Eligible property under Section 85 encompasses a broad range of assets that can be transferred from a sole proprietorship to a corporation tax-free. This includes:

Capital Property: Tangible and intangible assets that are used by the business over the long term, such as buildings, machinery, equipment, patents, and trademarks.

Inventory: Items held for sale in the ordinary course of business.

Certain Other Assets: This may include rights and licenses essential to the business operations, subject to specific criteria and exclusions set by the ITA.

It’s crucial to note that not all assets are eligible for transfer under Section 85. Exclusions include real property owned by non-residents and certain types of receivables. The determination of whether an asset is eligible requires a thorough analysis, often necessitating professional advice to ensure compliance and optimization.

The Consideration: Equity Participation

The consideration for the transfer of eligible property under Section 85 is uniquely structured to ensure that the transferring party receives shares in the corporation. This requirement is twofold in its purpose:

1. Equity Retention: It ensures that the individual or entity transferring the assets retains an ownership stake in the corporation, fostering a continued interest in the success and growth of the business.
2. Tax Deferral Mechanism: By receiving shares as consideration, the immediate tax consequences typically associated with asset disposition are deferred, aligning with the provision’s objective to facilitate business growth and restructuring.

The nature and amount of the shares received can vary, providing flexibility to structure the consideration in a way that meets the financial and strategic needs of both the transferor and the corporation.

Key Steps and Considerations in the Transfer Process

The process of transferring eligible property to a corporation under Section 85 involves several key steps and considerations:

1. Identifying Eligible Property: Begin with a comprehensive review of the business assets to determine which are eligible for transfer. This step is crucial in planning the scope of the rollover and identifying any assets that may require separate treatment.
2. Valuing the Assets: Accurately valuing the eligible property is essential for determining the fair market value (FMV) of the assets being transferred. This valuation will inform the negotiation of the agreed amount and ensure that the transfer meets the ITA’s requirements.
3. Structuring the Consideration: Decide on the structure of the share consideration, including the type and number of shares to be received. This involves strategic planning to align the equity structure with the future goals of the corporation and the interests of the transferring party.
4. Executing the Joint Election: Both the transferor and the corporation must complete and file Form T2057, Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation. This joint election signifies the agreement to apply Section 85 to the transfer and includes the agreed-upon values of the transferred assets.
5. Meeting Deadlines: Timeliness is critical, as the election must be filed by the deadline for the tax return of the year in which the transfer takes place. Ensuring all documentation is prepared and submitted on time is essential to avoid complications or the denial of the election.
6. Considering Tax Implications: While Section 85 facilitates tax deferral, it’s important to understand the future tax implications, both for the corporation upon eventual disposition of the assets and for the individual upon the sale of the received shares. Strategic planning can help manage these future liabilities.

Professional Advice: A Prerequisite for Success

Given the complexity of the Section 85 rollover process, seeking professional advice is not just beneficial but necessary. A tax professional can provide invaluable assistance in identifying eligible property, valuing assets, structuring the consideration, and navigating the filing requirements. Their expertise ensures that the transfer is executed in compliance with the ITA, while also strategically positioning the corporation for future growth and success.

Transferring business assets into a corporation under Section 85 of the ITA offers a tax-efficient pathway for business restructuring. By carefully selecting eligible property, structuring the consideration appropriately, and meticulously following the prescribed steps, business owners can achieve a seamless transition to a corporate entity. With the right guidance and strategic planning, this process not only defers immediate tax liabilities but also sets the stage for the corporation’s long-term financial health and operational success.

Case Studies: Strategic Use of Section 85 Rollovers

Through the lens of real-life applications, the strategic use of Section 85 of the Income Tax Act (ITA) can be fully appreciated. This section presents a case study that exemplifies how leveraging this provision can lead to significant tax savings and financial restructuring benefits for individuals with business and personal assets. The focus is on an individual with multiple rental properties and a professional corporation, showcasing the innovative application of Section 85 to optimize their financial and tax situation.

Case Study: Optimizing Property Holdings and Reducing Personal Tax Liability

Background: An individual owned several rental properties personally. These properties had appreciated in fair market value (FMV) significantly and were subject to less debt compared to their value. Concurrently, the individual operated a professional corporation that generated substantial income, from which they drew both a salary and dividends. This high remuneration was partly necessitated by a sizable mortgage on their principal residence, leading to considerable personal tax liability.

Challenge: The primary challenge was the significant tax burden resulting from the high income required to service the personal mortgage. Additionally, while the rental properties were generating income, the interest expense on these properties, when held personally, did not offer the same tax advantages as it could if the properties were held within a corporation.

Solution: Utilizing Section 85 of the ITA, we devised a strategy to roll the rental properties into the individual’s corporation at their original cost basis. This transaction created a substantial shareholder loan balance in favor of the client due to the transfer of the properties’ equity into the corporation.

Subsequently, we refinanced the properties within the corporation, unlocking the equity built up in these assets. The proceeds from this refinancing were then used to repay the shareholder loan, providing the client with non-taxable funds.

Outcome: The client utilized the proceeds from the shareholder loan repayment to significantly pay down the mortgage on their principal residence. This strategic move reduced their need for higher personal remuneration, thereby lowering their overall personal tax liability.

Furthermore, by holding the rental properties within the corporation, we capitalized on the ability to deduct interest expenses related to the mortgages on these properties against the corporation’s income. This deduction was not available under the previous structure, where the properties were held personally.

Tax Savings and Financial Benefits: This strategic application of Section 85 resulted in several key benefits:

Reduced Personal Tax Liability: By decreasing the need for higher personal income to service the residential mortgage, the client’s personal tax burden was significantly reduced.

Tax-Efficient Debt Structuring: Refinancing the rental properties within the corporation and repaying the shareholder loan provided a tax-efficient means of reducing personal debt.

Enhanced Deductions: The ability to deduct interest on the business property mortgages within the corporate structure improved the overall tax efficiency of the client’s investment holdings.

This case study underscores the power of Section 85 rollovers as a tool for financial restructuring and tax optimization. By thoughtfully applying this provision, we were able to align the client’s business and personal financial strategies, resulting in substantial tax savings and improved cash flow management. It highlights the importance of considering all aspects of an individual’s financial landscape when planning for tax and demonstrates the value of professional advice in executing complex tax planning strategies effectively.

Conclusion: Charting a Path to Success with Strategic Tax Planning

The journey from a sole proprietorship to a corporation represents more than just a shift in business structure; it marks a pivotal evolution in a business’s lifecycle, opening new avenues for growth, sustainability, and success. As we’ve explored the strategic application of Section 85 of the Income Tax Act (ITA) and delved into the complexities of eligible property, considerations for transfer, and real-life case studies, the overarching theme is clear: navigating these waters requires not only a deep understanding of tax law but also a strategic approach to financial planning.

Navigating Complexity: The Imperative for Professional Guidance

The intricacies of the ITA, particularly concerning the rollover provisions of Section 85, underscore the necessity of professional guidance. This isn’t merely a suggestion but a critical component of successful tax planning and business restructuring. Compliance with the ITA’s provisions, accurate valuation of assets, and the meticulous management of the election process demand a nuanced understanding of both tax law and business strategy. Missteps can lead to significant financial consequences, while strategic actions can yield substantial tax savings and financial benefits, as illustrated in our case studies.

Engaging with tax experts—those who not only grasp the complexities of the law but can also anticipate the ramifications of strategic decisions—is essential. This professional guidance ensures that your business transition not only complies with legal requirements but also aligns perfectly with your long-term goals and vision.

Final Thoughts: Your Ambition, Our Guidance

Your ambition to transition from a sole proprietorship to a corporation, to grow your family-owned enterprise, or to optimize your tax strategy is a journey we are committed to supporting. With the right strategy and professional guidance, this transition can be executed not just with tax efficiency but with a clear focus on future growth and success.

The strategic use of provisions like Section 85 of the ITA represents a powerful tool in the tax planning arsenal, offering a pathway to minimize tax liabilities while restructuring your business for the next stage of its evolution. But beyond the technicalities and strategic maneuvers, our ultimate goal is to align our expertise with your ambitions, guiding you through the complexities of tax planning and corporate transitions.

By embracing the mechanisms within Canada’s tax framework and leveraging professional advice, family-owned enterprises can move forward with confidence, knowing that their tax strategies are not only compliant but optimized for their unique needs. This is a journey best undertaken together, where your vision for the future of your business informs every strategy we employ.

As we embark on this path, let us remember that the transition to a corporation, guided by thoughtful tax planning and strategic advice, is more than a legal or financial process—it’s a stepping stone toward realizing your business ambitions. Let’s ensure that your journey from a sole proprietorship to a corporation is as smooth, tax-efficient, and aligned with your goals as possible, paving the way for a future of growth, sustainability, and success.

 

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. ©2024 Shajani CPA.

Shajani CPA is a CPA Calgary, Edmonton and Red Deer firm and provides Accountant, Bookkeeping, Tax Advice and Tax Planning service.