Scott Park, CPA, CA
Many Canadians typically start their own business as a sole proprietorship. This form of business is quite common because it’s the simplest way to structure a business while minimizing costs. As the business grows, the topic of incorporating the sole proprietorship becomes something to think about. Here’s what you need to know when converting your sole proprietorship business into a corporation, which could save you thousands of dollars in taxes.
Going From a Sole Proprietorship to a Corporation
When transferring your business assets from a sole proprietorship to a corporation you are considered to have disposed of the assets at fair market value. If the assets of the business have increased significantly since you started, this would normally lead to a significant amount of tax that you would have to pay personally. Therefore, when you are transferring assets from your proprietorship to your corporation, you should only do so under the provisions of Section 85 of the Income Tax Act (“ITA”). These provisions allow for transfers to a corporation on a tax-free basis.
The Goodwill Value
A business will typically have two categories of assets:
The goodwill would be the collective intangible assets of the business. Goodwill is what someone would be willing to pay for the business up and above the price of the tangible assets. And since goodwill does not normally appear on the balance sheet of a sole proprietorship, it is perhaps the most common overlooked asset.
For the purposes of utilizing a Section 85 rollover, it is very important that the goodwill is valued and reported on the T2057 form. The goodwill can be a reasonable calculation performed by your accountant or by a Chartered Business Valuator (CBV) depending on the circumstances. Although some business owners may argue that there is no business goodwill to transfer to the corporation, it is a risky position to take. CRA could review the rollover transaction and deem a large gain on the transfer of the proprietorship goodwill if it is not specifically listed on the T2057 form. This would trigger unintended negative tax consequences that could result in thousands of dollars in taxes. This risk could simply be eliminated by just reporting goodwill on the T2057 election form.
The Section 85 Rollover
It is very important that the Section 85 rollover is done correctly, which is accomplished by having the proper supporting legal documents and filing the related Section 85 forms with CRA.
Although Section 85 rollover provisions are commonly used, this is a very technical area, so it is best to have a qualified CPA and business lawyer take care of the details. The combined accounting and legal fees can range anywhere from around $2,500 to $10,000 depending on the complexity of the transaction; however, it will save you thousands in taxes that would otherwise be payable to CRA.
If you don’t file a Section 85 rollover, either because you didn’t know, or because you didn’t want to go through the tough exercise of doing so, you’re in for a surprise. What will end up happening is that the CRA will reassess the transaction and bump up the sale price to the fair market value of the assets.
If the assets that you own, including goodwill, are valued at two-hundred thousand dollars, and you paid only fifty thousand dollars for them, then the CRA will impose capital gains tax on the gain of one-hundred and fifty thousand dollars. This will happen only if you do not file the T2057 election form pursuant to Section 85 of the ITA to transfer your assets from your sole proprietorship to your corporation.
It is important to note that I am glossing over the specific rules of Section 85 and focusing on the bigger picture of this topic in order to keep things simple for this blog article.
Filing the T2057 Election
As mentioned above, the T2057 form applies to elections made under Subsection 85(1) of the ITA. Transferors must file this form separately from any income tax return at the tax centre where they file their tax returns.
The deadline to file the T2057 form is the earliest date on which any of the parties to the election (i.e. transferor and transferee) has to file an income tax return for the taxation year in which the transfer occurred otherwise late-filing penalties would be applicable.
Disclaimer: The blogs posted on Scott Park & Co Inc. website provide information of a general nature. These blog posts should not be considered specific advice since each person's personal financial situation is unique and fact specific. Please contact us prior to implementing or acting upon any of the information contained in one of our blogs. Scott Park & Co Inc. cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.