Are you the sole proprietor of a Canadian business now earning enough profit to use incorporation as a tax advantage?
Right now, as a sole proprietor, you are entirely responsible for your business, which includes any incurred debt and lawsuits that may come your way via creditors or clients. If your profits put your income in a higher tax bracket, you’ll also end up paying more in taxes. If your business has grown enough for you to worry about these responsibilities, you’re ready to switch from a sole proprietorship to a corporation.
When you incorporate your business with the Canadian government, it becomes a business entity that is independent and will not pass on either its income taxes or its liability to you. Incorporation makes it much more difficult for someone to go after your personal assets if the business defaults on debts. Your life savings will be protected from any lawsuits and debt incurred by your company.
It’s common in Canada for a private corporation to be owned by a controlling shareholder who is an owner-manager. Business tax rates are lower than personal tax rates, so depending on whether your individual marginal tax rate is high enough (the combined federal and provincial taxes you pay on all sources of income at tax time), and if you don’t need those funds personally, you can leave that money in the business, and then take it out later when your personal tax rate is lower. Learn more by reading parts 1 and 2 of How to Incorporate a Business in Canada? Where we go over name search, whether to register federally or provincially, digital minute books, making by-laws, shares, shareholder agreements, annual filings, annual returns, annual general meetings, GST/HST, and payroll.
What’s a Section 85 Rollover?
The Section 85 rollover is a special election you file with the CRA after incorporating so that you can transfer your assets into the new Canadian entity without having to pay taxes. Essentially, you’re closing down the sole proprietorship business and selling it to a third party (you, via the private corporation). In order to make that sale tax-free, you have to file the rollover transfer. You must file this election before the next tax return, corporate or personal, whatever comes first. It’s important to note that this rollover will not eliminate tax indefinitely. The tax liability is simply deferred until the assets or shares of the corporation are eventually sold to another third party.
What’s the Value of your Business?
Before you fill out the T2057 Election form, you need to calculate the fair market value of your business, backed by income and assets. If your small business has fairly simple operations, you can use an online calculator or net income for the previous years to establish its value. How much would you sell the sole proprietorship for to any third party? Your assets probably include a desk, chair, computer, cell phone, office furniture, any equipment and/or tools, cash, money owing, and more.
One of those assets is “goodwill”, an intangible you’re selling along with the physical assets. These intangibles include brand recognition, company reputation, intellectual property (your “know-how”), customer lists and relationships, employment contracts, website and domain name, Google reviews, newsletter subscribers, and anything else that doesn’t have an accounting value. These intangibles actually make up a big part of the value of your company.
Some people who have not filed a rollover transfer have argued that it’s because their entire brand reputation is tied to them individually, so the brand would be worthless without them.
This claim would mean that there’s no value attributed to goodwill, which means no gain. There’s a risk that the CRA would disagree with this decision, in which case they could assess your goodwill at a higher value and charge the applicable tax. How do you argue with the CRA about how much your business was worth when you incorporated it?
If you’re just deleting your assets by not rolling them over, the CRA will know something happened, that you didn’t report the sale and you didn’t pay any tax on it. You’ll have to hire a tax lawyer because you didn’t file an election to make the sale tax-free. You sold assets, and you’ll have to pay tax on goodwill. The CRA could decide it was worth $100,000. It’s up to you as the taxpayer to make sure everything is filed correctly. Using a Section 85 Rollover provides a guarantee that no taxes would be incurred on the original transfer of the asset.
Make these Necessary Updates
When you’re incorporating, there are updates you must make, such as:
- Opening a new corporate bank account
- Applying for a corporate credit card, with the corporation’s name
- Closing your credit card merchant account and opening a new one
- Registering or updating your business number, corporate tax account, HST/GST, and payroll. Everything that is solely business-related you must close/transfer to the corporation
- Opening a new QuickBooks file. If you continue to use the same accounting file it will result in confusion, particularly for tax purposes since tax reporting for a sole proprietorship is different from a corporation.
- Notifying your insurance provider, as you may not be insured or paying premiums on a business that doesn’t exist anymore
- Change the name of your Zoom account, as well as other online accounts
- Changing the registration of a work vehicle via the Ministry of Transportation. If it’s used solely for business reasons, it should be owned by the Corporation as one of the assets
- Updating contracts and billing with clients and suppliers to reflect the new entity
- Recording the value of the assets in your new corporate books, as you are exchanging your assets for shares in the new corporation
If registering and maintaining a sole proprietorship was fairly straightforward, a corporation, however, is a whole other level of complexity and commitment. When transitioning from a sole proprietorship to a corporation, your business should take advantage of the Section 85 Tax Rollover. If you want an accounting partner for this next phase of business growth, feel free to contact us to see if we’re a good fit.