Understanding Section 85 Rollover: A Guide for Small Business Owners
Every business, big or small, starts with one individual, the sole proprietor, or a few individuals. There comes the point when you incorporate your business into a separate entity and transfer the assets and goodwill you built as a sole proprietor to the corporation. But the transfer or rollover of assets to the newly incorporated company brings personal tax implications. You can use Section 85 rollover to reduce tax bills from transferring your asset to your company and defer it when you sell it to a third party.This article will touch on the basics of the section 85 rollover and why, when, and how small business owners can use it.
What Is Section 85 Rollover?
A Section 85 Rollover allows sole proprietors to transfer eligible assets to a corporation on a tax-deferred basis. The rollover requires:
- An eligible transferor who is a taxpayer (individual, corporation, trust)
- An eligible transferee, a taxable corporation incorporated in Canada
- An eligible asset – depreciable, non-depreciable capital property, inventory, resource property, and more
As a transferor, you can transfer eligible assets to the corporation in return for company shares or a mix of share and non-share consideration. This consideration can either be fair market value (FMV) or adjusted cost base (ACB) (the cost of the asset + other costs incurred to acquire the asset).
Example:
John has a capital property with an ACB of $100,000 and an FMV of $120,000. He elects for section 85 and transfers the property to X corporation in return for $99,900 worth of shares and $100 in cash. As John sold the property at ACB, there was no capital gain. He incurs a $0 tax liability on this transfer under section 85 rollover.
How Section 85 Rollover Works For Small Business Owners
When you elect for Section 85 rollover, you can determine the amount at which you want to transfer the asset. Otherwise, you must transfer at FMV and realize the tax in the same year. Let’s see what a transfer would look like with and without Section 85 rollover.
Without Section 85 Rollover:
| Year | Event | Tax Implication |
|---|---|---|
| 1 | John sells property to X Corporation for $120,000 | John incurs $20,000 capital gain |
| 5 | X Corporation sells property for $150,000 | X Corporation incurs $30,000 capital gain |
With Section 85 Rollover:
| Year | Event | Tax Implication |
|---|---|---|
| 1 | John transfers property to X Corporation for $100,000 | John incurs $0 capital gain |
| 5 | X Corporation sells property for $150,000 | X Corporation incurs $149,900 capital gain |
As you can see, Section 85 rollover is beneficial for personal tax. It does not eliminate your tax liability but defers it to a future date when you sell the asset for a gain/loss. Also, note that corporations have a lower tax rate than individuals.
How Can Small Business Owners Elect for Section 85 Rollover?
Now comes the implementation part, which can become technical. Here are the steps:
- Before incorporating, determine the assets you want to transfer and calculate their value.
- Incorporate your business, get a business number, register with the CRA, and determine your shareholding structure.
- Transfer the assets using a Schedule 85 election to the corporation at the amount you decide. Document all transfers in a purchase and sale agreement.
- Complete the T2057 form and file it with your personal tax return and a purchase and sale agreement.
- Declare the capital gain tax on your personal tax return.
Section 85 Rollover Process
Important: You must elect for Section 85 before the tax return deadline of the sole proprietor or the corporation, whichever is earlier. The CRA does accept late elections within three years from the original deadline, but with penalties.
All these steps are technical and should be undertaken with the help of lawyers and accountants. Ghumans can help you effectively use section 85 rollover for various use cases and asset types like customer lists, web content, or subscribers, where your only cost is your time.
By understanding and properly implementing Section 85 rollover, small business owners can significantly reduce their tax burden when incorporating their business, allowing for smoother transitions and continued growth.