Introduction
Many sole proprietors and self-employed individuals reach a point where their business becomes more profitable than expected, making incorporation a strategic move. Incorporating can provide tax advantages, limited liability protection, and increased business credibility. However, transferring business assets to a corporation can trigger capital gains tax, as the Canada Revenue Agency (CRA) treats the transfer as a disposition at fair market value (FMV).
The Section 85 Rollover allows sole proprietors to transfer eligible assets to a newly incorporated business on a tax-deferred basis, avoiding immediate tax liabilities. Understanding which assets qualify and following CRA filing requirements is essential for a smooth and tax-efficient transition.
1. Why Sole Proprietors Incorporate Their Business
Transitioning from a sole proprietorship to a corporation offers multiple benefits:
- Lower corporate tax rates: Corporations benefit from the Small Business Deduction (SBD), reducing income tax compared to personal tax rates.
- Limited liability protection: A corporation separates business and personal assets, reducing personal financial risk.
- Access to business funding: Incorporated businesses have better access to loans, investors, and grants.
- Tax deferral opportunities: Owners can retain earnings in the corporation and control personal income withdrawals.
However, transferring assets to a corporation without proper planning can result in capital gains tax on appreciated assets.
2. How the Section 85 Rollover Works for Sole Proprietors
Under Section 85 of the Income Tax Act, a sole proprietor can transfer eligible business assets to a Canadian corporation without triggering immediate tax, as long as:
- The sole proprietor receives at least one share in the new corporation.
- The assets are transferred at a price between their tax cost and fair market value (FMV).
- A joint election (Form T2057) is filed with the CRA by the tax return deadline.
This allows the business to continue operating under a corporate structure while deferring capital gains taxes.
3. Eligible and Ineligible Assets for a Section 85 Transfer
Not all business assets qualify for tax-deferred rollover treatment under Section 85.
a. Eligible Assets (Can be transferred tax-free)
- Capital property, including depreciable assets such as equipment, vehicles, and office furniture.
- Goodwill, including brand reputation and business name value.
- Accounts receivable, if related to business operations.
- Inventory, including work-in-progress (WIP), but excluding real estate inventory.
- Canadian and foreign resource property, if applicable.
b. Ineligible Assets (Subject to immediate tax upon transfer)
- Real property (land and buildings used for business operations).
- Real estate inventory (property held for resale, such as rental properties).
- Prepaid expenses, such as rent, insurance, and other advance payments.
Important: Ineligible assets must be sold to the corporation at FMV, triggering capital gains tax if appreciated in value.
4. Tax Considerations When Using Section 85 for Incorporation
While Section 85 defers income tax on transferred assets, business owners should consider additional tax implications:
a. Requirement to Receive Shares from the Corporation
- The sole proprietor must receive at least one share in the new corporation.
- These shares can be common shares, preferred shares, or a combination of both.
b. Fair Market Value (FMV) Transfer Price
- The total consideration received (shares + any additional payments) must equal the FMV of transferred assets.
- If the transfer price is below FMV, the CRA may reassess the transaction and impose penalties.
c. Filing a Joint Election with the CRA
- The business owner must file Form T2057 with the CRA by the tax return deadline for the year of transfer.
- Late filings may result in penalties or loss of tax deferral benefits.
d. Additional Tax Liabilities (Not Covered by Section 85)
- GST/HST may apply if the transferred business assets exceed $30,000 in value.
- Land Transfer Tax (LTT) may be due on real estate transfers.
- Provincial Sales Tax (PST) may be applicable in some jurisdictions.
5. Common Mistakes to Avoid in a Section 85 Business Transfer
Sole proprietors should avoid these pitfalls when transitioning to a corporation:
a. Failing to Transfer Eligible Assets Correctly
- Not all business assets are eligible for tax deferral—transferring ineligible assets without planning can lead to unexpected tax bills.
b. Not Obtaining a Proper Valuation
- Transferring assets at an incorrect value can result in CRA audits.
- A professional business valuation is recommended to establish FMV.
c. Missing the Filing Deadline for Form T2057
- Late filings result in loss of tax deferral and immediate capital gains tax liability.
d. Not Considering Future Tax Planning
- Incorporation should align with long-term tax goals, such as income splitting, estate planning, and tax-efficient salary/dividend strategies.
Conclusion
For sole proprietors looking to incorporate, the Section 85 Rollover provides a tax-efficient way to transfer eligible business assets to a corporation while deferring capital gains tax. However, careful planning, accurate asset valuation, and timely CRA filing are essential to ensure compliance and maximize tax benefits.
It’s advisable to consult with a tax professional specializing in business incorporation and crypto tax planning to navigate the complexities of Section 85 and optimize tax efficiency.
If you have any questions or require further assistance, our team at Block3 Finance can help you.
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