Are you a business owner that is ready to incorporate? If you aren’t sure, take a gander at our blog entitled “Should I Incorporate My Business?” (Should I Incorporate my Business?). If you know you’re ready, there’s something you need to consider which you might not have thought about – the transfer of your business from yourself to the corporation.
Many people assume that once you form a corporation, the corporation can just pick up operating your business where you left off and you can cease operating as a proprietorship with no consequences. This is not necessarily true. In actuality there is usually a transaction which occurs between you and your corporation – a sale. And in Canadian tax, a sale to a related party must generally occur at fair market value.
This topic can be confusing, so before we get any further let’s look some of the basic steps involved in moving a business from a proprietorship to a corporation:
- Set up a new corporation (with a little help from your friendly neighborhood accountants and lawyers).
- Identify all of the assets of your proprietorship and determine their fair market values.
- Transfer (“sell”) all of the assets identified in step 2 to your corporation.
- Continue operating your business as usual, but as a corporation.
While most of the steps above are fairly straight-forward and just involve a couple of weeks of paperwork, Step 2 often poses a problem. Consider what assets your proprietorship owns, and what your corporation is going to give you in return. There may be physical assets such as equipment, computers, maybe even a building, which are all easy to place a value on. But there may also be an intangible asset – Goodwill.
Goodwill is your reputation. It’s your brand. It’s all the customer relationships you’ve built up, all the great staff you’ve hired and trained who know how to run your business. It may be what allows your business to make a profit, and it may have value.
How do we calculate value of goodwill? There are standard valuation models which we are familiar with using as accountants, but in the end there are opinions involved when valuing intangible assets. We use our professional judgement and the tools available, and we make our best estimate.
Fair Market Value
As mentioned above, a sale must generally occur at fair market value between two related parties. But what if your goodwill is worth $200,000? All of a sudden you’re personally selling an asset to your corporation for $200,000 – you’ll need to pay tax on that! That doesn’t seem fair.
Section 85 Rollover Election
Luckily for us there is a mechanism in Canadian tax which allows for a tax-deferred “rollover” of assets from you personally to a corporation. Using Section 85 of the Income Tax Act, we can move the goodwill into the corporation for a nominal value, which will not trigger any taxable gain for you personally. Phew. Section 85 elections are somewhat complicated, and specific items (including shares) must come the other way from your corporation, so make sure to use a qualified accountant to help you in filing one.
Purchase and Sale Agreement and Price Adjustment Clause
When your assets are sold to your corporation they are done so by way of a “purchase and sale agreement”. You should consider getting this agreement formally documented with the help of a lawyer and including a clause which can adjust the value of consideration given in case the Canada Revenue Agency disagrees with your estimate of the fair market value.
Is All This Really Necessary?
You could ignore all the above and just start operating your corporation – at your own risk. As mentioned, the CRA could knock on your door and tell you that they think your goodwill was valuable, in which case you could have a personal tax bill. However, if one were theoretically arguing against using a Section 85 election, one could argue the following:
- CRA seems, in general, to not target small businesses making this type of sale transaction.
- Your goodwill may indeed have no value – perhaps the only intangible value that exists is embodied in you, the proprietor.
Essentially the legal and accounting work of a Section 85 election is an insurance policy. So you need to ask yourself the following – what are the possible consequences of not doing a Section 85 election, and are you willing to take the risk?
Chris Brien, CPA, CA