If you’re a sole proprietor or in a partnership considering incorporating your business, Section 85 rollover can be a crucial tool in your financial toolkit. Here’s why it’s important and what you need to know.

Why is Section 85 Important?

Incorporating your business can offer several benefits such as limited liability, tax advantages, and increased credibility. However, transferring assets from your sole proprietorship or partnership to a new corporation can trigger immediate tax consequences. This is where Section 85 of the Income Tax Act comes into play.

Section 85 Rollover allows you to transfer assets to a corporation without triggering immediate tax on any capital gains. Instead, the tax is deferred until the corporation sells the assets. This deferral can significantly ease the financial burden of incorporation, making the transition smoother and more economically viable.

Goodwill and Section 85

Goodwill represents the reputation, customer loyalty, and other intangible factors that contribute to the business’s earning power. When incorporating, goodwill can be a significant asset. Including goodwill in a Section 85 rollover can:

– Enhance the value of the newly incorporated business

– Allow for tax deferral on the transfer of this intangible asset

– Facilitate a smoother transition by incorporating the business’s established reputation.

Risks of Not Using Section 85

Failing to utilize Section 85 rollover when transferring assets, including goodwill, to a corporation can lead to immediate tax consequences:

1. Immediate Tax Liability: Transferring assets without a Section 85 rollover triggers capital gains tax at the time of transfer, resulting in a significant tax bill.

2. Reduced Cash Flow: Paying taxes upfront can strain cash flow, limiting funds available for reinvestment in the business.

3. Higher Initial Costs: The immediate tax hit can increase the overall cost of incorporation, making it less financially attractive.

4. Loss of Tax Deferral: Without Section 85, the opportunity to defer taxes and spread the financial impact over time is lost.

5. Complexity in Asset Valuation: Properly valuing assets, especially intangible ones like goodwill, without deferring taxes can complicate the incorporation process.

Tax Implications

The main benefit of using this strategy is tax deferral. By rolling over the assets at their original cost, you postpone the capital gains tax. However, it’s important to remember that this tax is deferred, not eliminated. The corporation will owe the tax when it eventually sells the assets.

Benefits of Section 85 Rollover

– Tax Deferral: Avoid immediate capital gains tax, which can help maintain cash flow.

– Smooth Transition: Facilitate the move from a sole proprietorship or partnership to a corporation without a hefty tax bill

– Asset Consolidation: Combine business assets into a corporate structure efficiently.

Potential Consequences

– Future Tax Liabilities: Deferred taxes will eventually need to be paid. Planning for these future liabilities is essential.

– Complexity: The process requires precise documentation and adherence to specific rules. Mistakes can be costly.

– Eligibility Criteria: Not all assets or situations qualify, so understanding the limitations is important.

Case Study: From Partnership to Corporation

Imagine a partnership owning a commercial property and equipment. By incorporating and using Section 85 rollover, they can transfer these assets to the new corporation without immediate tax consequences. This deferral allows them to reinvest in the business, improving cash flow and funding growth initiatives.

How Does Section 85 Work?

1. Identify Eligible Assets: Determine which assets from your sole proprietorship or partnership are eligible for the rollover. Common assets include equipment, real estate, shares, and goodwill.

2. Complete Necessary Documentation: Use the T2057 form to document the asset transfer and elect the transfer value.

3. Transfer the Assets: Transfer the assets to the corporation in exchange for shares.

FAQs

Q: What if my business has significant capital gains?  
A: Section 85 allows you to defer those gains, providing immediate financial relief.

Q: How does the T2057 form work?  
A: This form documents the transfer and sets the elected value, which determines the deferred tax amount.

Q: Are there risks involved?
A: Yes, improper documentation or misunderstanding the rules can lead to costly errors. Consulting a CPA is crucial.

Conclusion

Section 85 rollover is a powerful tool for sole proprietors and partnerships transitioning to a corporate structure. By deferring taxes and facilitating a smooth asset transfer, it can significantly benefit your business. For personalized advice and expert assistance, contact our team at CPA Logic. We’re here to help you navigate the complexities of incorporation and tax planning.