The Section 85 Rollover....The Section Eighty-what?!
We get that a lot!
Whether it’s a company restructuring for tax-planning purposes or creditor proofing or a successful sole-proprietor looking to incorporate - the Section 85 rollover is a valuable tax deferral tool, if used correctly.
There are a variety of scenarios where the Section 85 rollover might come in handy, but for the purpose of this post, we will cover the two scenarios that we see most often.
Disclaimer: The information below is simplified for illustrative purposes only. The Section 85 rollover can get technical and can be used for a variety of reasons. Assets transferred can be done at varying amounts. You should not try to perform a Section 85 rollover yourself, if your tax experience is limited. Please consult a tax accountant for more information.
The premise behind a Section 85 rollover is to transfer assets (with a built-in gain) on a tax-deferred basis from one company (corporation or sole proprietorship for example) to another corporation. The Section 85 rollover is prepared through CRA’s T2057 form.
In other words, electing to use the Section 85 rollover mechanism allows for assets to be transferred to a Canadian Corporation without triggering tax. If this mechanism did not exist and assets needed to be transferred from one company to another, a sale at fair market value (FMV) would be triggered, resulting in possible tax implications.
For example, if an individual owned a piece of land personally and has held it for many years (with the presumption that the land has increased in value), and for one reason or another, this individual wanted to move the asset to a corporation (perhaps they were developing the land, which necessitated running the operations in a Canadian Corporation), then they have two options:
Sell the land to the corporation for FMV.
The corporation would hold the land asset at the FMV amount that it purchased it at
The individual would have immediate personal tax consequences from the sale of the land (i.e. a capital gain for the difference between the initial cost and the FMV sale).
Elect to transfer the land to the corporation using a Section 85 rollover.
The corporation would hold the land asset at the elected amount (for example, the initial cost).
The individual would have no immediate personal tax consequences from the transfer of the land asset.
If the land is sold in the future, tax consequences would arise in the corporation at that time.
It is worthwhile to note that a Section 85 rollover would not need to be used if assets that have not increased in value are being transferred (i.e. office equipment, furniture, etc.). In this situation, you can have the corporation purchase the assets at cost or the depreciated value and avoid the rollover altogether.
The two Section 85 rollover scenarios that we experience most often are as follows:
Sole-proprietor business looking to incorporate
Shareholder of corporation looking to add a holding company (holdco) to his/her organizational structure for tax planning and/or creditor proofing
SOLE-PROP LOOKING TO INCORPORATE
A common Section 85 rollover scenario involves someone’s self-employed venture that took off and has become successful and it now makes sense to incorporate from a tax standpoint.
This being said, ‘success’ via revenue or profit isn’t the only criteria to measure against, so it’s worthwhile to note that an assessment of the sole-proprietorship needs to be made to determine whether a Section 85 rollover is warranted.
If a Section 85 rollover is warranted, it is common to transfer assets from the sole-proprietorship to the corporation at FMV (other options exist as well, but are beyond the scope of this post). The individual (shareholder) takes back shares from the corporation equivalent to the FMV of the assets transferred into the corporation. So, for example, if an individual transfers $50,000 worth of assets, they would take back $50,000 worth of shares (preferred or common shares).
It’s important to have a valuation done or at least a reasonable attempt made to understand the value of assets transferred, including intangible assets such as ‘goodwill’ (brand, customer lists, etc.). More often than not, goodwill is an asset that is transferred.
In this scenario, there is no immediate tax consequences. If the shares or assets of the corporation are sold at a future date, tax is paid then (if the transaction includes a gain on the sale of shares or assets).
INTRODUCING A HOLDING COMPANY
It is quite common for business owners to incorporate their operating company (opco) and hold shares personally. Only after some time (and some success), do they realize that a holdco would be useful. A holdco is a great tax planning and creditor proofing tool in the following ways:
To be eligible for the capital gains exemption (i.e. to ensure you remain onside when assessing the various capital gains exemption rules).
To transfer money from an operating company to a holdco to safeguard assets.
In this example, a holdco needs to be incorporated (this is similar to any other incorporation but should be discussed with an accountant and lawyer to ensure that nothing is missed).
Prior to the rollover transaction, the shareholder would own shares of holdco and opco separately (i.e. holding shares in two separate incorporated companies simultaneously).
In the Section 85 rollover, the opco would transfer shares to the holdco. The shareholder would take back shares from the holdco as consideration.
The final result has the shareholder owning shares of the holdco, which in turn, owns shares of the opco.
The opco can now transfer funds to the holdco via dividends tax-free, thereby helping with creditor proofing. Depending on the situation, this also helps by staying onside with one of the capital gains exemption criteria.
There you have it - you’re now a Section 85 rollover profess...Not so fast! As mentioned above, this is a high-level overview of the usefulness and mechanics of a Section 85 rollover. There is lots more to know, including technical details that may be unique to specific situations, so we advise that you always consult a tax accountant prior to proceeding with a rollover.
The Section 85 rollover is a common and important tool that is used extensively in the Canadian business landscape and allows for growing companies to move quickly and pivot without any immediate tax consequences.
Disclaimer: The information above is simplified for illustrative purposes only. The Section 85 rollover can get technical and can be used for a variety of reasons. Assets transferred can be done at varying amounts. You should not try to perform a Section 85 rollover yourself, if your tax experience is limited. Please consult a tax accountant for more information.