INCORPORATING THE BUSINESS (SECTION 85)

When a sole proprietor incorporates, the business assets are moved from the individual to a new corporation. Without special rules, that transfer would be treated as a sale at fair market value, triggering recaptured capital cost allowance, capital gains on goodwill and other tax. Section 85 of the Income Tax Act allows the assets to be transferred on a tax-deferred basis in exchange for shares. This page explains how the rollover works, the limits on the amounts that can be elected, the filing requirements, and the other steps involved in moving a business into a corporation. Whether to incorporate at all is discussed on the main Tax page.

HOW THE SECTION 85 ROLLOVER WORKS

• Transfer for shares: the proprietor transfers eligible property to a taxable Canadian corporation and receives consideration that must include at least one share of the corporation.

• Elected amount: the proprietor and the corporation jointly choose an amount, within limits, that becomes the proprietor's proceeds of disposition and the corporation's cost of the property.

• Deferral: electing an amount equal to the tax cost of each asset means no gain or recapture is triggered. The deferred gain is carried into the cost of the shares the proprietor receives.

• Boot: the proprietor can also take back non-share consideration, such as a promissory note from the corporation, up to the elected amount without immediate tax. Boot above the elected amount triggers a gain.

ELIGIBLE PROPERTY

• Included: capital property, such as equipment, vehicles and buildings; inventory other than real estate held as inventory; and intangible property such as goodwill and customer lists.

• Real estate inventory excluded: land held as inventory, such as by a property developer, cannot be rolled over under section 85.

• Accounts receivable: these are usually transferred under a separate joint election on Form T2022 (section 22), so the corporation can deduct any that later turn out to be bad debts.

LIMITS ON THE ELECTED AMOUNT

For each asset, the elected amount cannot be more than its fair market value or less than the value of any boot received for it. Within that range, the following floors apply.

• Inventory: not less than the lower of its cost and its fair market value.

• Non-depreciable capital property: not less than the lower of its adjusted cost base and its fair market value.

• Depreciable property: not less than the lowest of its undepreciated capital cost (UCC) in the class, its cost and its fair market value. Electing UCC avoids recapture.

• Self-generated goodwill: its cost is nil, so the elected amount can be set at a nominal amount, usually $1, deferring the entire gain.

FILING THE ELECTION

• Form T2057: the election is made on Form T2057, Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation, signed by both the proprietor and the corporation and filed electronically or on paper.

• Deadline: the earliest of the filing due dates for the proprietor and the corporation for the tax years in which the transfer occurred.

• Late filing: an election can be filed up to three years late with a penalty of 1/4% of the excess of fair market value over the elected amount for each month late, to a maximum of $100 a month and $8,000 in total.

• Price adjustment clause: the transfer agreement should state that if the CRA disagrees with the fair market values used, the price will be adjusted, protecting against unintended benefits.

WORKED EXAMPLE

A proprietor incorporates a business with these assets: equipment with a UCC of $20,000, original cost of $40,000 and fair market value of $30,000; inventory costing $15,000 and worth $15,000; and self-generated goodwill worth $200,000.

• Elected amounts: equipment $20,000, inventory $15,000 and goodwill $1, for a total of $35,001.

• Consideration: the corporation issues a promissory note for $35,000 and common shares for the balance of the $245,000 fair market value.

• Result: no recapture on the equipment, no gain on the inventory or goodwill, and $35,000 can later be withdrawn from the corporation tax-free by repaying the note. The deferred gain of about $210,000 sits in the low cost base of the shares.

WHAT STAYS WITH THE PROPRIETOR

• Losses: unused non-capital losses from the proprietorship stay with the individual and cannot be transferred to the corporation.

• Home office carryforward: unused business-use-of-home expenses are tied to the proprietorship and cannot be used by the corporation.

• Final fiscal period: the proprietorship's last fiscal period ends on the date of the transfer, and income to that date is reported on Form T2125 in the proprietor's return.

OTHER STEPS IN INCORPORATING

• GST/HST: the corporation needs its own business number and GST/HST account, and a joint election under section 167 of the Excise Tax Act can avoid charging tax on the transfer of the business.

• Payroll: the corporation becomes the employer and needs its own payroll account. Employees' service is normally treated as continuous.

• Land transfer tax: transferring real property to the corporation may trigger provincial land transfer tax, even though section 85 defers income tax.

• Contracts and licences: leases, supplier contracts, bank accounts, insurance policies and licences must be transferred or reissued in the corporation's name.

• Lifetime capital gains exemption: goodwill sold directly by a proprietor does not qualify for the exemption, but shares of a qualifying small business corporation can, up to $1.25 million, if the conditions, including a 24-month holding period, are met. Incorporating can make the exemption available on a future sale.

KEY POINTS

• Shares required: the corporation must issue at least one share as part of the consideration.

• Elect at tax cost: electing UCC, cost or adjusted cost base defers recapture and gains.

• Boot up to the elected amount: a promissory note can let the owner withdraw that amount tax-free later.

• Joint filing: Form T2057 must be filed by both parties by the earliest filing deadline.

SOURCES

• Income Tax Act: sections 22, 85 and 110.6.

• Canada Revenue Agency: Information Circular IC76-19R3, Transfer of Property to a Corporation under Section 85; and Form T2057.

• Excise Tax Act: section 167.