Section 85 rollovers are used fairly regularly by small businesses. There are several situations that may give rise to performing a Section 85 rollover. A situation that we encounter regularly, which results in the use of a rollover is where an individual first starts a small business as a sole proprietor and then incorporates later. In this case, as the unincorporated business grows and revenues increase, incorporating becomes more attractive because of certain tax advantages and the desire to minimize exposure to personal liability.
During the time that the unincorporated business was operating, the business may have accumulated assets of value such as equipment, goodwill and cash from revenues. If the sole proprietor transfers these assets to the corporation, such a transfer may trigger a gain and attract capital gains tax. To defer this negative tax consequence, business owners carry out a Section 85 rollover where the individual transfers the assets to the corporation and receives common shares in the corporation in return. The business owner and the corporation then make a joint election under Section 85 of the Income Tax Act. This is the rollover. Following the rollover, the corporation runs the operation in the same way that the business owner did previously, with the business owner still in charge, using all of the assets required to do so.
For example, let’s suppose that Mr. John Smith starts up a landscaping business called “Green Acres.” He operates the business for a few years without incorporating. During those years, he has built up a large client base with lots of revenue and has accumulated numerous assets, including landscaping equipment and office equipment. Mr. Smith, on the advice of his accountant and lawyer, incorporates a company called “Green Acres Inc.” Green Acres Inc. will now run the landscaping business with Mr. Smith acting as the sole director, officer and shareholder. For Green Acres Inc. to operate properly, Mr. Smith must transfer the business assets to the corporation. However, if Mr. Smith transfers these assets without performing a Section 85 rollover, the transfer could trigger a gain for Mr. Smith in the view of Canada Revenue Agency (CRA). Mr. Smith would then be required to pay capital gains tax in relation to this gain. To defer this consequence, Mr. Smith will need to perform a rollover.
When performing a rollover, care must be taken to ensure that the value of the assets being transferred to the corporation equals the value of the amount received in exchange. If the amount received is over valued then the elected amount will be deemed to be the fair market value of the transferred property. It is important to obtain proper accounting and legal advice throughout the process to ensure that the rollover is performed in the manner required by CRA.
It is important for business owners to take note that a Section 85 rollover provides only a deferral or postponement of tax. It does not amount to tax avoidance. Any increase in value of the assets that was not realized when the transfer occurred will be taxed at the time the assets are sold or otherwise disposed of. The business owner transferring the assets may also be taxed on the deferred gain when he or she disposes of the share(s) received in exchange for the assets at the time the rollover was performed.
The above scenario is one case where a Section 85 rollover is used. Section 85 rollovers are not limited to these situations and may be used in other cases, including estate freezes. If you are a small business owner you may wish to consult with accounting and legal professionals to determine whether your business may benefit from this type of transaction.