January 08, 2021
Sweet! You’ve reached the next stage of growth in your business and you’re ready to incorporate. You will need to transfer assets from proprietorship to a corporation. Depending on the asset transferred, there may be tax implications on the disposition of assets by the sole proprietorship to the corporation.
There are two categories of assets
The first category is physical assets. Examples include equipment, computers, vehicles, furniture, and so forth.
The second category in intangible assets; and you may not think about it but one of the biggest assets for your business is an intangible one, and that is goodwill. Goodwill, by definition, is what someone would pay for your business over the cost or price of the physical assets. So it is simply viewed as the approximate value of a company’s brand names, reputation, or long-term relationships that cannot otherwise be represented financially.
The total value of any business can be described as the accumulative sum of its physical tangible assets plus the value of its goodwill. So goodwill is essentially equal to the difference between the total value minus the standalone value of its tangible physical assets.
Often, when you transfer property to a non-arm’s length person such as a corporation that you control, you have a deemed disposition of the property for proceeds equal to the fair market value (FMV) of the property. Assuming the FMV exceeds the cost of the property, the transfer can trigger capital gains or ordinary income. While the good news is that you’ll now be able to take advantage of tax deferral techniques .
The transfer is made by means of a “section 85 election”, which is filed with your tax return and the corporation’s tax return . The election allows a complete rollover (no immediate gain), or partial rollover (some immediate gain), depending on the “elected amount” on the transfer. The election is actually a joint election, in that it is made by you and the corporation. The election is made on Form T2057.
In order to qualify for the election, as consideration for the transfer of the property you must receive at least one share in the corporation. You may also receive non-share consideration – often called “boot” – but the boot may affect your elected amount.
The elected amount becomes your proceeds of disposition of the property transferred to the corporation. Therefore, for example, if you elect at your cost of the property, you will have a nil gain and nil income inclusion from selling the property to the corporation.
The elected amount also becomes the corporation’s cost of the property. And the elected amount, net of any boot taken back, becomes the cost of your shares received as consideration.
There are three general limits to the elected amount.
The elected amount cannot exceed the fair market value (“FMV”) of the property;
The elected amount cannot be less than the lesser of the FMV of the property and its tax cost; and
Subject to the first limit above, the elected amount cannot be less than the FMV of any boot.
In most cases, if possible, you would elect at your tax cost of the transferred property. As noted, this would allow a tax-free rollover on the transfer.
However, in some cases you may want to deliberately trigger some or all of the accrued gain in respect of the property by electing at an amount greater than your tax cost.
For example, you may have current or previous capital losses than could offset any triggered gain. By electing an amount greater than your tax cost of the property, the gain would not be taxable if it were offset by your losses; and the result is that the corporation’s cost of the property and your cost of the shares taken back would be increased accordingly, leading to lower taxable capital gains somewhere down the road.
As another example, you may have transferred property that qualifies for the capital gains exemption – that is, qualified small business corporation shares or qualified farm or fishing property. Assuming you have a sufficient capital gains exemption available, you can elect to trigger a gain on the transfer of the property to the corporation, and again the greater elected amount means a greater cost of the property for the corporation and a greater cost of your shares taken back, leading to eventual lower taxable capital gains.
Unfortunately, you cannot trigger a loss on the transfer if you and the corporation are “affiliated”. In such case, any loss will be a superficial loss and therefore denied.
The election must be filed by the earlier of your tax return due date and that of the corporation for the taxation year in which the transfer took place. Late filing within three years of that day is allowed, subject to a penalty.
It’s really important for you to get this right because this could save you a lot of money.
The information provided on this page is intended to provide general information.