Corporate Tax

What is a Section 85 Rollover and Why Would I Use it?

Melissa Gayfer, CPA
/
September 13, 2022

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A Section 85 Rollover can be used to reduce personal taxes when incorporating your sole proprietorship. This article will explain how a Section 85 Rollover works and give some examples to illustrate this tax planning technique.

Section 85 Rollover Guide

A Section 85 Rollover can be used to reduce personal taxes when incorporating your sole proprietorship. This article will explain how a Section 85 Rollover works and give some examples to illustrate this tax planning technique.

We'll also look at the Form T2057 that is needed to file the election and show an example of a completed form.

If you have been operating your business as a sole proprietorship and have determined it’s time to incorporate, you may want to look at using a Section 85 Rollover to transfer assets to your new company.

What is a Section 85 Rollover?

A Section 85 rollover is an election in the Canadian Income Tax Act that business owners can file to transfer property (typically business assets) into a corporation.  

A Section 85 rollover allows taxpayers to defer all or part of the tax consequences that would otherwise arise on the transfer of the assets into the corporation.

If you have been operating your business as a sole proprietorship and have determined it’s time to incorporate, then this may be for you!  

Not sure if it’s time to incorporate? Check out our article on when it makes sense to incorporate your business.

What is a Section 85 Election?

You may also hear it described as a Section 85 election.  Both terms are used interchangeably but the election is literally the thing that’s filed to create the section 85 rollover.

A Section 85 election is a special election filed with the CRA after incorporating a sole proprietorship. It allows sole proprietors to transfer assets of the sole proprietorship into the newly incorporated business on a tax-deferred basis.

This can reduce personal taxes owing (potentially to $0) when the assets of the sole proprietorship are transferred to the new corporation. 

However, it does not eliminate tax indefinitely. The tax liability is simply deferred until the assets or shares of the corporation are eventually sold to a third party.

The process to file this election generally involves lawyers and accountants working together to prepare the sale agreement and forms for CRA. 

The election form is called a T2057 Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation

The form T2057 must be filed at the earlier of:

  • The next sole proprietor’s tax return deadline
    Or
  • The first corporate tax return deadline

We’ll go into some detail below on what the form T2057 looks like when it’s filled out.

What is the Purpose of a Section 85 Rollover?

There are a number of reasons why a taxpayer might use a Section 85 rollover.  

These typically include:

  • Sole proprietors can defer taxes when incorporating their business (in some cases)
  • Estate planning
  • Transferring assets from one business to another
  • Crystalizing capital gains 

The most common reason for using a section 85 rollover is to defer taxes when incorporating your sole proprietorship so we’ll focus on this scenario in this article.

When Should a Section 85 Rollover be Used?

We’ll look at a couple of common scenarios relating to incorporating your business when a Section 85 rollover can be beneficial to use.

These are:

  1. When incorporating a sole proprietorship and goodwill exists already
  2. When transferring the rights of something into a corporation

Use a Section 85 Rollover When Goodwill Exists

The first scenario we will look at is when you have a sole proprietorship that has goodwill.

If you have been operating your sole proprietorship for a while and have built up a strong reputation, then you’ve likely created some goodwill. 

For example, goodwill could be in the form of a customer list or subscribers to your service or newsletter.  

After incorporation you are essentially carrying on the operations of the sole proprietorship which included that goodwill. You’ll continue to build on the already established goodwill within the corporation, so you have technically transferred your goodwill to the new corporation.

Some examples where you may have goodwill include:

  • Subscribers - Subscribers to a service or newsletter.
  • Customer List - A customer list or customer relationships that are tied to the organization and not just an individual (e.g. an accounting firm has a list of trusted clients that are expected to remain if the business was sold)
  • Patents - Patents, trademarks and copyrights
  • Web Content - Website content that generates revenue (written information, videos, online courses, podcasts, etc.)

In the case of the business with Goodwill, you can use a Section 85 rollover to transfer that goodwill to the corporation without paying tax on the value of the goodwill.

Section 85 Example 1 - Transfer Goodwill to the Corporation

Bob has decided to incorporate his sole proprietorship which sells online courses.

Bob needs to transfer the website and course content to his new corporation (NewCo) so that NewCo has the legal right to use and sell the developed courses.

No cost other than Bob’s personal time was incurred to create the online courses. 

A Chartered Business Valuator has determined the fair market value of the online content is $100,000.

Option 1: Section 85 Rollover not used, later sold to third party for $150,000

If no section 85 rollover is used, the website must be sold to the corporation at its fair market value of $100,000.

  • Bob reports a capital gain of $100,000 on his personal tax return when he transfers the content to the company at its appraised fair market value of $100k.
  • NewCo records an asset (the content) of $100,000 on its balance sheet.

Then if in 5 years NewCo sells the content as an asset for $150,000, it would have a capital gain on that sale.

  • NewCo reports a capital gain of $50,000 ($150,000 proceeds less $100,000 cost)
  • Tax Results:

When the Section 85 Rollover is not used.

  • Year 1 Incorporation - Bob is taxed on $100,000 of gains in year one when the content asset is transferred into the corporation.
  • Year 5 Asset Sale - The corporation is taxed on a $50,000 gain in year five when it sells the content as an asset to a third party.

This scenario shows that Bob has paid a bunch of tax right away in year one when the goodwill asset is transferred to the corporation.  

Next we’re going to see how a Section 85 rollover can defer that tax until the asset is sold to a third party.

Option 2: Section 85 Rollover used, later sold to third party for $150,000

If a section 85 rollover is used, Bob can elect to sell the website asset to the corporation for a nominal amount (such as $1) which minimizes his initial capital gain.

A section 85 election is filed when Bob transfers the asset to the corporation so he only has a capital gain of $1.

  • The S85 election deems the transfer of the goodwill to take place at $1 instead of $100k the fair market value. 
  • The S85 rollover has allowed Bob to limit his capital gain to $1 on his personal tax return in year one.
  • NewCo reports an asset of $1 and issues shares to Bob in the amount of $99,999 with a tax cost (AKA Paid up Capital or PUC) of $1.

Then if in 5 years NewCo sells the content as an asset for $150,000, it would have a capital gain on that sale.

  • In 5 years when NewCo sells the content, it reports capital gain of $149,999 ($150,000 proceeds less the $1 cost of the goodwill)

When the Section 85 Rollover is used

  • Year 1 Incorporation - Bob is taxed on a gain of $1 in year one when he transfers the goodwill asset to the company.
  • Year 5 Asset Sale - The corporation is taxed on $149,999 of gains in year five. 

Using the section 85 rollover has deferred the tax owing on the original gain of $100,000 from year one to year five.

Section 85 Example 2 - Transfer the Rights of Something to a Corporation

In scenario 2, we’ll look at using a section 85 rollover to defer capital gains tax on transferring the rights of something to a newly incorporated company.

In this scenario, Jimbo operates a sole proprietorship that sells online courses that he has made. 

Jimbo is incorporating and would like to transfer the rights of the course content to the corporation so it can continue to use and sell the courses.

CRA considers this type of scenario to be a sale from the sole proprietorship to the new corporation. 

For CRA’s tax purposes, the assets must be sold at fair market value which could be a significant amount.  The cost base of the assets is $0 because their creation just required Jimbo’s time and no actual monetary costs to create.

The sale could result in a personal capital gain equal to the fair market value of the goodwill/content. Capital gain = proceeds - cost of asset

The Section 85 Rollover let’s Jimbo elect a sale amount other than fair market value, so that he can choose the amount of the capital gain to incur. Likely he’ll want to choose a nominal amount such as $1 to defer the capital gain when transferring the rights to the company.

In return, Jimbo would obtain shares of the company and possibly a promissory note / loan of the new corporation that can be repaid back to him at any point in time.

How to Complete a Section 85 Rollover

Completing a Section 85 Rollover and filing the applicable Form T2057 is something that business owners should seek professional help with. However, it is helpful to understand how the process works, so here’s a rundown for you!

In this example, we’re using Bob again who runs a business selling online courses as a sole proprietorship.  He would like to transfer the goodwill (online courses) asset into his new corporation using a S85 rollover.

His courses have a cost base of $0 but a fair market value of $100,000 as determined by a business valuation.

Step 1 - Determine the Value of the Goodwill

The first step is to determine if the business has any goodwill and what its value is.  This is typically done by first consulting your accountant to see if goodwill may exist.  

If it is likely to exist, then a Chartered Business Valuator or an accountant with business valuation experience can be consulted to determine the value of the goodwill.

For this example, Bob has already spoken to a business valuator and determined that his business has goodwill worth $100,000.

Step 2 - Incorporate a New Company (NewCo)

The first step is to incorporate the operating company. This is pretty straightforward and can be done through a lawyer or a service like Ownr (check out our Ownr review here).

It’s helpful to consult with a lawyer when using a Section 85 rollover as they’ll be able to make sure the share structure is created properly to achieve the desired result.

The company will also need to obtain a business number and register with the CRA for corporate income tax purposes.

Step 3 - Transfer Assets to Company with S85 Election and Form T2057

Shortly after incorporating NewCo, all of the property necessary for NewCo to carry on Bob’s business should be transferred to NewCo using a Section 85 Election.

The goodwill asset (online courses in this example) can be transferred to the company at an elected amount instead of its fair market value.  

For this, we’re going back to Bob’s example where the courses have a fair market value of $100,000 but Bob would like to transfer them into the company at $1 to defer capital gains.

Complete and File Form T2057

This is accomplished by completing Form T2057 and filing it by mailing the form to Bob’s applicable tax centre.

Use a Purchase and Sale Agreement

All asset transfers should be documented by a purchase and sale agreement which will make reference to the elected amount ($1 in this case). 

The agreement should also state that the NewCo is acquiring all or substantially all of the property necessary for it to carry on the business.

Include a Price Adjustment Clause

It can also be a good idea to include a “price adjustment clause” in the purchase agreement.  The price adjustment clause allows the transferring parties to make an adjustment to the transaction price if needed. 

This can happen in the event that a third-party such as the Canada Revenue Agency determines that the fair market value of the transferred property is greater or less than the amount otherwise determined by the parties.

Step 4 - Declare any Capital Gains on Personal Tax Return

Filing the election will result in a small amount of capital gains. In this example, Bob will have $1 of capital gains to declare.

While this is nominal, it is important for Bob to remember to declare the $1 of capital gains on his income tax in the year that it occurred. 

How to File a Form T2057 for a Section 85 Rollover

Once the new company has been created and asset values have been determined it’s time to prepare and file the T2057 form.

Here is a link to the sample T2057 form used in this example.

Step 1 - Fill Out Information for Transferor and Transferee

The first step is just some data entry relating to who the transferor and transferee are.  In our example, we have Bob as the transferor and his new company (NewCo) as the transferee.

T5027 Section 85 Election Form Sample

Step 2 - Fill Out Penalty Area if Late Filing T2057

If you’re filing the T2057 late, you’ll then need to fill out the penalty area to calculate the penalty amount owing. 

If you’re filing the T2057 on-time, then you can skip this section.

T5027 Section 85 Election Form Sample

Step 3 - Complete the Information Checklist

The next section asks you questions about the filing and you can check “Yes” or “No” to answer each question.

T5027 Section 85 Election Form Sample

In Bob’s case the answers are:

  1. He does have a written agreement relating to the transfer - Yes
  2. He did choose to add a price adjustment clause. - Yes
  3. No other persons besides Bob owned or controlled shares in NewCo - No
  4. No non-arm’s length rollover exists between two or more corporations - No
  5. Bob is not a non-resident of Canada - No
  6. None of the properties are capital properties in this case (computer equipment for example) - No
  7. The agreed amount for the transferred properties is not based on a FMV estimate on the valuation day. - No
  8. No election under subsection 26(7) is being filed (not very common) - No 

Shares of capital stock of a private corporation were not included in the property disposed of so we entered N/A in the corporation’s name section.  This could also just be left blank.

Step 4 - Enter the Description of Shares Received

Bob has received 1,000 Class C non-voting shares in exchange for the goodwill transferred to the company.  

T5027 Section 85 Election Form Sample

This information will come from the purchase agreement and by discussing with your accountant and lawyer.

Step 5 - Enter Information on the Property Transferred (disposed and received)

In Bob’s case, it was just the website and online course content that was transferred.

T5027 Section 85 Election Form Sample
  • It had a fair market value of $100,000 as previously determined
  • It’s cost base was $0 (column A)
  • The agreed upon transfer amount was $1 (Column B)
  • Consideration received was 1,000 Class C shares
  • Fair market value of consideration was equal to the FMV of the website and course content in this case so $100,000.

Step 6 - Sign and Date the Election

Both the transferor and the transferee need to sign the election and add a date at the bottom.  

T5027 Section 85 Election Form Sample

In this case, Bob has signed both sections as both the transferor and authorized officer of the transferee corporation.

Step 7 - Mail the Form, Related Schedules and Purchase Agreement

The last step is to mail the Form T2057 and all related schedules as well as the purchase agreement.

The form T2057 must be filed at the earlier of:

  • The next sole proprietor’s tax return deadline
    Or
  • The first corporate tax return deadline

It can be mailed to the tax centre of the transferor.  Bob can find his tax centre’s mailing address by going to this CRA page here

How to Determine the Fair Market Value of Goodwill

Valuing intangible assets, such as websites and goodwill is never an exact science as it is based on a number of factors such as the revenue that it generates.

This calculation can vary even further based on the type of intangible asset. Comparing selling prices of similar websites on Flippa may help provide a basis for the fair market value of a website.

As this is a complex and somewhat subjective calculation it is typically recommended that a Chartered Business Valuator is engaged to do the work. We know a few good ones and would be happy to recommend them if you’re looking.

Should a S85 Always be Used When There’s Goodwill?

Not exactly.

We’ll get a bit technical here but it’s just so you understand the concept and know when to reach out to a business valuator.

In some cases it could be argued that the entire brand reputation is tied to you individually, as the operator, and therefore the brand would be worthless without you.

In this case the value attributed to the goodwill could be considered insignificant, which would result in no gain and no tax on transfer to the corporation.

There is always a risk that CRA would disagree with this determination, in which case they could assess your goodwill at a higher value and charge the applicable tax. Using a Section 85 Rollover would provide a form of assurance that no taxes would be incurred on the original transfer of the asset.

Summary

As with any tax planning scenario, there is no one size fits all answer. This is especially true for the complex Section 85 Rollover.

The purpose of this article is to make you more aware of the issue so that you know to consult with a tax professional if you’re ever in this situation. They will be able to help you determine whether or not this is a recommended approach for your specific situation and hopefully save you a bunch of tax!

A Section 85 Rollover can be used to reduce personal taxes when incorporating your sole proprietorship. This article will explain how a Section 85 Rollover works and give some examples to illustrate this tax planning technique.

If you have been operating your business as a sole proprietorship and have determined it’s time to incorporate, you may want to look at using a Section 85 Rollover to transfer assets to your new company.


Article by
Melissa Gayfer, CPA
.
Originally published
September 13, 2022
.
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