You may have heard the term ‘rollover’ or 'section 85' from other entrepreneurs who’ve gone through the transition from a sole proprietorship to a corporation. The concept is often overlooked but is a rather important process to take into account when making the transition.
When you’re operating as an unincorporated entity, be it as an individual/sole proprietor or partnership, you’re forming all kinds of relationships. You’ll have relationships with suppliers, customers, competitors, etc. all of which contribute to the growth of your business. By the time you’re ready to incorporate, you’ve likely developed some amount of goodwill.
Your goodwill is your brand. It’s the sum of all the relationships, contracts, agreements, etc. that you’ve made while operating under your current structure.
When you incorporate, you’ll likely want to carry your goodwill with you. You’ll probably continue to maintain the relationships you developed as a sole proprietor while continuing to build on and strengthen your reputation and brand. Since you developed this goodwill before you incorporated, you’re really transferring it to your corporation.
Officially, from the CRA’s perspective, transferring your goodwill to your corporation is a sale. In effect, you are selling your customer lists, relationships and brand equity to your corporation.
In general, a sale or disposition to a related party is made at fair market value. So how does this affect you?
Presumably the goodwill you’ve created through all your hard work has a value. While it’s fairly subjective, there are a number of ways to come up with a number that stem from standard valuation techniques. Regardless of what technique you use, you should arrive at some number that represents the goodwill that you’ve built up as a sole proprietor.
Let’s say your goodwill is worth $50K. Since you didn’t buy the goodwill from someone else and built it from scratch, it cost you nothing. When you incorporate and transfer your goodwill to your corporation, effectively you’ll have sold it for $50K and therefore realize a capital gain of $50K for which you’ll have to pay tax on.
Why should you have to pay tax when you really haven’t sold anything to a third party?
That’s where the Section 85 rollover comes in.
The Section 85 rollover allows you to transfer the goodwill and other assets, at an agreed upon amount to the corporation.
In our example, by using a Section 85 rollover you would transfer your goodwill to your corporation at a nominal amount, thereby deferring any capital gains tax. The corporation would then own your brand equity and you’d have no tax to pay on the transfer.
To actually carry out a Section 85 rollover, you’ll have to do a valuation of goodwill or any other asset you’re transferring. You’ll then have to fill out a special tax form called a T2057, which must be supported by a Section 85 rollover agreement.
So does every individual that incorporates need to go through the Section 85 rollover process?
Not necessarily – the CRA does not typically target small businesses making this transition. In many cases it can be argued that the goodwill of the business is directly tied to the owner and therefore negligible. That being the case, there is always an element of risk that should be considered before making a decision one way or another. You can then look at the Section 85 rollover as insurance that you’re safe from any CRA assessment on your goodwill.
As with any insurance policy, there are a number of factors to consider before deciding it’s right for you. Since the Section 85 rollover process is a complicated one, it’s a good idea to consult with a professional before you determine whether or not to go down that road.