Are you in the next stage of growth in your business? Are you ready to incorporate? Are you ready to speak to an accountant?
If the answer is yes, then be ready for some additional admin work.
You may have heard the term ‘section 85 rollover’ from other small business owners who’ve gone through the transition from a sole proprietorship to a corporation. The concept is an important process to take into account when making the transition.
When you’re operating as an unincorporated entity, for example an individual/sole proprietor, you’re forming all kinds of relationships. You’ll have relationships with suppliers, customers, competitors, etc. all of which contribute to the growth of your business. By the time you’re ready to incorporate, you’ve likely developed some amount of goodwill.
Goodwill is the sum of all the relationships, contracts, agreements, etc. that you’ve made while operating under your current structure. When you incorporate, you’ll likely want to carry your goodwill with you. You’ll probably continue to maintain the relationships you developed as a sole proprietor while continuing to build on and strengthen your reputation and brand. Since you developed this goodwill before you incorporated, you’re really transferring it to your corporation.
Is a Section 85 rollover right for you?
Officially, from the CRA’s perspective, transferring your goodwill to your corporation is a sale. In effect, you are selling your customer lists, relationships and brand equity to your corporation.
In general, a sale or disposition to a related party is made at fair market value. So how does this affect you?
Presumably the goodwill you’ve created through all your hard work has a value. Let’s say your goodwill is worth $100K. Since you didn’t buy the goodwill from someone else and built it from scratch, it cost you nothing. When you incorporate and transfer your goodwill to your corporation, effectively you’ll have sold it for $100K and therefore realize a capital gain of $100K for which you’ll have to pay tax on.
Is it fair?
Why should you have to pay tax when you really haven’t sold anything to a third party? This is where the Section 85 rollover comes in. The Section 85 rollover allows you to transfer the goodwill and other assets, at an agreed upon amount to the corporation.
In our example, by using a Section 85 rollover you would transfer your goodwill to your corporation at a nominal amount, thereby deferring any capital gains tax. The corporation would then own your brand equity and you’d have no tax to pay on the transfer.
To actually carry out a Section 85 rollover, you’ll have to get an expert to do a valuation of goodwill or any other asset you’re transferring from your sole proprietorship business to the new corporation. You’ll then have to fill out a special tax form called a T2057, which must be supported by a Section 85 rollover agreement.
So does every individual that incorporates need to go through the Section 85 rollover process?
Not necessarily – the CRA does not typically target small businesses making this transition. In many cases it can be argued that the goodwill of the business is directly tied to the owner and therefore negligible. That being the case, there is always an element of risk that should be considered before making a decision one way or another. You can then look at the Section 85 rollover as insurance that you’re safe from any CRA assessment on your goodwill.
As with any insurance policy, there are a number of factors to consider before deciding it’s right for you. Since the Section 85 rollover process is a complicated one, it’s a good idea to consult with a professional before you determine whether or not to go down that road.
LOPC is your trusted tax adviser and Calgary Accountants. Do you have any tax issue bothering you? We’d love to help. Book a complimentary call with us on +1 (587) 999-6200 and learn how we can assist you better structure your business transactions for tax efficiency. Visit our blog or website and learn more: www.lopc-cpa.com
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