Moving from Sole Proprietorship to Incorporation
You’ve spent years slowly building up your business, and after months of dedication and perseverance, you have finally reached the point where you can incorporate. At long last you can take advantage of the different tax deferral techniques available, saving you a great deal of money. So is incorporating a good plan for you?
What does incorporation entail exactly? Well, as bizarre as it seems, you are effectively selling your own company back to yourself at fair market value, and you are responsible for paying tax on the capital gains you have incurred. This is a very strange, but very true, fact of incorporating, and something that should be kept in mind if one is seeking to incorporate.
So what exactly are you paying for? Well as sole proprietor of your company, the assumption is you’ve gained a certain client base before you have grown large enough to incorporate, and that client base comes with a certain degree of goodwill. In a sense, you are essentially selling that goodwill that you’ve built up to your new corporation. Though no money will change hands, the government will see this as a sale and expect the taxes accordingly. It may not seem very fair, as you have personally built up this goodwill from absolutely nothing in the first place.
However this is where a “rollover” or “section 85” comes into play. It allows you to transfer the so called “goodwill” over at a nominal price, allowing you to avoid any capital gains tax. It will require you to fill out a special tax form, but that’s par for the course. Does this mean that your company should go through the complicated process of a so-called “section 85”? Typically smaller companies can get away with incorporating for a nominal price, even without a section 85 rollover of goodwill, but you can never be sure. Consider a section 85 a kind of insurance, to make sure that the CRA doesn’t nail you for undervaluing your initial incorporation.
Overall, it is important to talk to an expert in such matters, rather than just guessing and hoping for the best. In cases of financial importance it is always important to talk to an expert. In many cases, a section 85 is the best course of action, as well as the safest.