By: Jayson Schwarz

People usually start their businesses the simplest and most inexpensive way they can. Quite often this means they trot down to the Ministry and register as a partnership or sole proprietorship. This is cheap and easy and allows them to take advantage of any start-up losses on a personal level. This may not however protect them from liability or be the best tax solution once the business becomes profitable.

Once the business starts to grow most people realize the thing to do is incorporate. Incorporation satisfies 2 basic needs: firstly it shields the owner from personal liability, as an example from such things as product liability claims and secondly there are tax deferral benefits.

The first thing the entrepreneur learns is that if an asset has gained value and then is transferred it attracts capital gains tax. Hmmmm, we need to avoid this, we need relief and frankly the Government recognized it would be unfair to not encourage businesses to grow properly.

The Income Tax Act (“the Act”) does provide some relief to businessmen intending a transfer of their personal assets into a corporation when the time to incorporate the business comes.  Specifically, Section 85 of the Act contains provisions permitting a deferral of income tax in such asset transfers.  This is clearly beneficial in circumstances where the disposition of property would otherwise give rise to recognition of a gain by the transferring taxpayer and he would have to pay capital gains tax.  

Thus, it is possible to shift the assets of one’s business over to a corporation tax-free by making what is referred to as an election under Section 85 of the Act.  Everyone really knows this as a TAX FREE ROLLOVER. In exchange for the assets transferred to the corporation, the transferor must receive consideration which is equal to the fair market value of the assets transferred. This consideration must include at least one common share and may include a promissory note from the corporation.  Care must be taken, however, to ensure that the cash or promissory note taken back does not exceed the tax cost of the assets before the transfer.  A legal purchase and sale agreement must also be prepared and signed by all interested parties. Only a lawyer can do this for you together with your accountant.

Rollovers permitted under Section 85 of the Act are not solely limited to situations in which a sole proprietor or partnership simply wishes to change to a corporation it can also be used in the transfer of property to a corporation in the context of an estate freeze and/or income splitting reorganization. There are other uses for the section and you should consult your lawyer to see how they apply to you.

To recap, in case of the small business entrepreneur, the provisions of Section 85 would apply on the transfer if the assets of the proprietorship into the corporation are made in exchange for shares of this corporation.  The end result would be that the business originally carried on in an unincorporated manner has now been acquired by the corporation on a tax deferred basis. The corporation will then run the business in place of the entrepreneur personally. Do not forget however that the entrepreneur is still in charge. He will be the director, the president or whatever he wants to be after the rollover.

Don’t forget to do this right formal written agreements need to be prepared and entered into between the entrepreneur as vendor and the corporation as purchaser. It will have some of the normal provisions of an arm's length agreement of purchase and sale including all necessary conveyances of title to assets. Do it right and this affords a method to change and promote growth in a fashion that can only help the business and the businessman. Good Luck!!!!

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