What to Know Before Incorporating, Part 2
What is Section 85?
Section 85 of the Income Tax Act (ITA) allows an entity to provide assets to a corporation in exchange for shares in that corporation. The entity providing the assets could be a partnership, an individual, or even another corporation.
The transaction needs to be done at fair market value. Accountants often refer to this transaction as a Section 85 Rollover.
Although often considered during the process of incorporating, there are other times when a Section 85 Rollover can be useful.
For instance, if the corporation is bringing on a shareholder who possesses valuable intellectual property or a strong book of business that will help the corporation in the long run, it might use a Section 85 Rollover.
What is Fair Market Value?
At times, Fair Market Value (FMV), can be easily determined, while at other times, it is very subjective. The transaction needs to be well documented by an Asset Purchase Agreement containing a distinct Price Adjustment Clause, and that the Fair Market Value assigned to the transaction is well documented.
It is important to note that no matter how well-documented the Fair Market Value is, CRA can come back and force an adjustment to the value used in the purchase agreement. Make sure you consult a professional to determine the FMV.
What is an Asset Purchase Agreement?
A simple explanation is that an Asset Purchase Agreement is a contract between two entities outlining the assets being purchased and the price being paid for them.
What is a Price Adjustment Clause?
The Price Adjustment Clause specifically outlines the remedies that will be undertaken should the CRA disagree with the Fair Market Value used in the asset purchase agreement and require an adjustment to the price used.
Without a Price Adjustment Clause, tax consequences could be more severe than if one was included in the agreement.
Why go through a Section 85 Rollover?
There are a lot of reasons why one would undertake a Section 85 Rollover. Some common ones include:
- Incorporating to limit liability as the business expands;
- Incorporating to sell the business and take advantage of the Lifetime Capital Gains Exemption and limit the taxes payable;
- Incorporating to bring on investors or partners;
- Bringing on a new shareholder into an existing corporation who has valuable intellectual property or some other asset that will have a long-term value.
The Lifetime Capital Gains Exemption
The Lifetime Capital Gains Exemption (LTGE) is one of the largest incentives to business owners available. It allows the individual to sell Qualifying Small Business Shares and avoid paying any capital gains tax on the sale up to a limit.
As of 2024, the Lifetime Capital Gains Exemption is $1,016,636. This means that the seller of the shares does not have to pay capital gains tax on the first million dollars of capital gains!
It’s important to note that certain conditions need to be met for the Lifetime Capital Gains Exemption to be used. If you are considering it, make sure you consult a professional and plan far ahead of the sale to ensure you can take this big tax break.
To give an idea of the potential tax savings, an individual in the highest tax bracket in Canada could save over $270,000 in taxes.
As you can see, it makes a lot of sense to try and claim the Lifetime Capital Gains Exemption
A Simple Example
An entrepreneur, a sole proprietor, incorporates their business to sell it and take advantage of the Lifetime Capital Gains Exemption.
The entrepreneur provides assets with a fair market value of $950,000 including some equipment, inventory, and a strong book of business. However, the corporation is brand new and has no money.
One way to organize this transaction might be to have a promissory note owed by the corporation to the entrepreneur in addition to the value of the shares being acquired.
When the loan is repaid, it is not income and is not taxable; and when the entrepreneur sells the shares, assuming they qualify for the Lifetime Capital Gains Exemption, they will save a lot of tax pain.
Remember…