I’ve talked about the pros and cons of different business structures in an earlier article, but what happens when you start out as a sole proprietor or in a partnership, and later want to incorporate? The transition needs to be seamless, so that the corporation can step right in to your shoes and carry on business.
This is something I deal with regularly, and unfortunately it’s not a simple process. It’s difficult for a layman to do without some professional advice from your lawyer, and accountant or tax nerd. The details count here – to the point that writing this blog post took about 8 hours of work. Doing it the wrong way could lead to paying unexpected taxes, interest and penalties, muddy the water about who owns business assets, and stick you with personal liability for things that you thought were pushed over to the corporation. Fear not, intrepid entrepreneur – there’s a way through the maze…
OK, what’s so friggin’ complicated?
There are three steps to incorporating an existing business:
- Incorporation and organization of a new company;
- Sale of the business or partnership to the corporation; and
- Joint election to defer the paying of capital gains tax.
Each step has its quirks, which I’ll explain below. There are a bunch of other business steps that you should take to make the transition seamless – this handy dandy checklist should help. Every case will be different – but at least you can get an idea of the key tasks. The rest of the article deals with the process on the legal side. Let’s git ‘r done:
Take the usual steps to incorporate your company –name search, and filing of the articles of incorporation with the fee payable to the Ministry. If you’ve registered your existing business’ name, and want to use a similar name for the new corporation, you’ll have to file a signed letter, or completed consent form with the articles of incorporation. You may want to include a share price adjustment clause in the articles of incorporation, in case the Canada Revenue Agency (CRA) puts a different value on the sale than you did.
The value of the shares that you’ll own will depend on the sale price. It’s important that the numbers add up, and are consistent between the sale agreement, the documents in the corporation’s minute book, and the election to defer the capital gains tax that you file.
2. Selling the Business: Tax Rollover
Once your corporation is all set up, it is a “person” (and a taxpayer) in the eyes of the law. It can own property, enter into contracts, and do all that other fun stuff that you do for work. The problem is that the corporation doesn’t actually own anything yet, or have a right to take over your business. You own the corporation, and you also own the assets of the existing business, but they’re different people entirely. In order to merge the two, you’ve got to sell your sole proprietorship to your corporation.
The CRA will want you to pay capital gains tax on the sale. When you started your business, it was worthless. Through your hard work, it has grown in value – accumulating cash, equipment, inventory, contracts, real estate, etc. – which is a capital gain. When you sell the business, the capital gain is realized, and 50% of that amount will be added to your personal income as capital gains tax.
As pleasant as that sounds, you’re allowed to put off payment of the capital gains tax. Since you’re actually only selling the business back to yourself – you’re still are the beneficial owner of the business through your shares of the corporation – you’re not actually realizing the capital gain. You still have to pay it when you actually sell the business to someone else – but you can avoid it for now. This is known as a “tax rollover”. Lawyers, accountants, and various other nerds call this “deferring the realization of a capital gain”. Bottom line is you’ll have more money left to keep your business afloat.
To defer the capital gain, you must sell the business to the corporation at fair market value, in exchange for shares of the corporation. This is done with a “Section 85(1) Rollover Agreement”, which is a contract of sale between you and the corporation. You keep a copy, and a copy goes in the corporation’s minute book. Having a clear agreement on file is very important – the CRA likes to scrutinize these types of sales closely in order to head off tax evasion.
There are two main parts to the rollover agreement – the sale contract, and the financial terms – mostly the value of the assets, and the shares they’re being exchanged for. The sale contract should cover the following points:
- Agreement to buy and sell
- Shares and other compensation issued in return
- Agreement to make a joint election to defer the capital gain under Section 85 of the Income Tax Act
- Price adjustment clause – in case the CRA decides that the value of the assets is different than you say it is
- Representations and warranties – that you and the corporation have the legal capacity to buy and sell the assets
- General provisions – about how the contract is to be interpreted, and so forth
You can find examples on the interweb – Appendix A or B of this article here is a good starting point – though I don’t recommend trying to do this without legal and tax advice. The consequences of screwing it up could cripple your business if you don’t have the cash to pay the tax bill.
The financial terms – usually laid out in a table as an attachment to the contract – can get tricky. The CRA deems the assets of the business to be sold at fair market value. Some assets – especially goodwill – are hard to value. Others have depreciated or grown in value since you got them. Other assets might have a constant value, or cost nothing to acquire, but still generate income. The same goes for liabilities – though typically you don’t transfer many, if any, liabilities in these sales. You should get your accountant to value the assets, and determine the sale price of each class – or the “Elected Amount”. In the contract, you can set a price for each “class of assets” as a group, rather than breaking it down for each item. Still, your accountant should keep the working papers used to determine the amounts declared, in case the CRA asks for justification.
Typically, the following classes of assets will be sold:
- Non-Depreciable Capital property
- Some securities or investments
- Some real estate
- Some patents
- Depreciable property – property with a definite useful life
- Furniture, equipment, electronics, tools, spare parts
- Vehicles and accessories
- Buildings and the systems in them (HVAC, plumbing, electrical, etc)
- Eligible capital property
- Goodwill – reputation, customer lists, business name
- Some securities or investments
- Incorporation costs
- Some patents
- Non-real estate inventory
3. Joint Election
No, I don’t mean the big issue in the next Federal campaign. It’s actually just more paperwork. Once the rollover agreement is all done and signed, the final step to deferring the capital gain is to file an “Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation.”
This riveting document is the CRA’s Form T2057. It uses much of the same information from the rollover agreement. It’s best to get your accountant to help you fill it out. The CRA will scrutinize the rollover closely. If you screw it up, you can amend the election form, but you can’t revoke an election once it’s filed.
That’s a lot of stuff to deal with for what seems like it should be a simple process. I strongly recommend that you don’t try this at home. It’s a tax-driven transaction – which means that your accountant should be calling the shots on the financial terms, and your lawyer should be papering the details. It’s usually a modest legal and accounting bill, which can protect you from an ugly capital gains tax bill, and the interest and penalties that come with it. Lawyer up!
Good luck out there!