April 07th, 2021

Sole Proprietor to Incorporation & Section 85 Rollovers
 
Frequently, small business owners will initially operate as a sole proprietorship in the early stages of business development. This can be beneficial as it facilitates the deduction of business losses against other personal income and reduces legal, accounting, and administrative costs until the business’ viability has been demonstrated. As a business grows, however, the desire to limit liability, facilitate raising funds through the sale of shares and the ability to defer taxes by retaining corporate profits within the corporation and pay dividends in lieu of salary often make incorporation preferable.
Unfortunately, the sole proprietor learns that if an asset has gained in value and then is transferred it attracts capital gains tax. Fortunately, the Government recognized it would be unfair to not encourage businesses to grow properly. Thus, when a sole proprietor incorporates his or her business, section 85(1) of the Income Tax Act (the “Act”) allows the business owner to transfer business assets out of the sole proprietorship and into a corporation without triggering tax liabilities due to a disposition of property.[1] This is known as a Section 85 rollover.

Section 85 Conditions:
There are 5 primary conditions for determining the applicability of a section 85 rollover, these include:

1.Eligible transferor;
2.Eligible transferee;
3.Eligible property;
4.Consideration consists of at least one share of capital stock; and
5.A joint election must be filed by the prescribed deadline.
​
An eligible transferor includes individuals (i.e. a sole proprietor), trusts and corporations.[2] An eligible transferee must be a taxable Canadian corporation (i.e. the newly incorporated business)[3] A corporation is a taxable Canadian corporation if it was incorporated in Canada (and therefore deemed to be a resident of Canada by section 250(4) of the Act) or a resident of Canada from June 18, 1971and is not tax exempt under the Act.[4]
 
Eligible property is defined in Section 85(1.1) of the Act and includes[5]:

• Depreciable capital property (includes eligible capital property);
• Non-depreciable capital property;
• Canadian resource properties;
• Foreign resource property;
• Inventories; and
• Real estate property owned by a non-resident but used in a business carried on in Canada.

 
Section 85(1) transfer requires that, in exchange for the eligible property, the eligible transferor must receive at least some share consideration.[6] The eligible transferor may also receive a non-share compensation in exchange for the eligible property, but the total compensation package must include shares in the corporation and must not exceed the fair market value of the property transferred.[7]
 
The joint election is a filing that must be made with the Canada Revenue Agency using the prescribed form (T2057) in order for Section 85(1) to apply to a disposition of property.[8]
 
Section 85 Elected Amounts:
When filing a joint election, the transferor and transferee must choose an elected amount, which represents the proceeds of disposition for the transferor and the cost to the transferee corporation. The actual value exchanged must be FMV (i.e., the corporation must pay the sole proprietor FMV for the transfer) but the elected amount is the deemed value for the tax purpose of avoiding capital gains tax. The Act prescribes the following upper and lower limits on the elected amount:[9]

1. The elected amount cannot exceed the FMV of the property at the time of the transfer.
2. The elected amount cannot be less than the FMV of the non-share consideration received by the transferor.
3. The elected amount cannot be less than the lesser of the FMV of the property and the cost amount of the property to the transferor at the time of disposition.
4. Where ii. and iii. differ, the greater of the two amounts represents the lower limit.

Example:
If a Section 85 rollover is warranted, it is common to transfer assets from the sole proprietorship to the corporation at FMV (but elect at cost and take back shares equal to FMV). The individual (shareholder) takes back shares from the corporation equivalent to the FMV of the assets transferred into the corporation.  So, for example, if an individual transfers $50,000 worth of assets, they would take back $50,000 worth of shares (preferred or common shares).
 
It’s important to have a valuation done or at least a reasonable attempt made to understand the value of assets transferred, including intangible assets such as ‘goodwill’ (brand, customer lists, etc.).  More often than not, goodwill is an asset that is transferred.
 
In this scenario, there is no immediate tax consequences.  If the shares or assets of the corporation are sold at a future date, tax is paid then (if the transaction includes a gain on the sale of shares or assets).
 
Conclusion:
 
It is important for business owners to take note that a Section 85 rollover provides only a deferral or postponement of tax. It does not amount to tax avoidance. Any increase in value of the assets that was not realized when the transfer occurred will be taxed at the time the assets are sold or otherwise disposed of by the newly incorporated business. The Section 86 rollover can be an important election that can help small businesses lower their tax burden when they want to expand or make changes in their business structure. Use this if you want to convert your sole proprietorship business into a corporation but ensure you seek qualified advice from a lawyer and your accountant before doing so.
 
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[1] Income Tax Act, RSC 1985, c 1 (5th Supp). [ITA].
[2] Ibid at s 85(1).
[3] Ibid at s 89(1).
[4] ITA, supra note 1.
[5] Ibid.
[6] Ibid.
[7] Ibid at s 85(1)(f).
[8] Ibid at s 85(6).
[9] Ibid at ss 85(1) (a), (b), (c).