Common Canadian Tax Schemes for Estate Planning
Section 85 Rollover: What is a rollover and why is it important?
Section 85 is a rollover tax-saving tool that allows a taxpayer (individual, company or trust) to transfer property to a Canadian corporation without incurring the transfer-related tax consequences. This is typically used when a taxpayer wants to incorporate and therefore must transfer the assets to a corporation because the corporation is a separate legal entity.
You may ask why does this matter? Well, Under normal circumstances when an individual transfers an asset to a corporation it would trigger taxation because there is a disposition of an asset by the transferor. With a Section 85 Rollover, the transfer of the asset can be recorded at book value on the balance sheet of the corporation, thereby avoiding the immediate recognition of accrued gains. This means you can transfer ownership without the fear of the taxman chasing you, keeping money in your hands to re-invest in your business. Although you are able to avoid the recognition of accrued gains it does not mean you must, the law does permit you to recognize gains if you so choose. This entirely depends on the elected amount recorded in the Section 85 Rollover form. Someone may do this if they have a need for cash however do not want to lose control of the asset.
Who qualifies for a Section 85 Rollover?
- If the transferor is either an individual, corporation or a trust.
- The transferee is a taxable Canadian corporation
- The asset rolled over is a property that meets the eligibility guidelines
- The consideration received from the transferee must include at least one share of capital stock
- A joint agreement must be made by both parties. They then must put this agreement into legal writing and file it by the prescribed deadline
What kinds of assets are eligible for Rollover?
Eligible Capital Property refers to intangible assets, including goodwill, customer lists, intellectual property trademarks etc.
- Capital Property: Capital Property that increases in value and any other property that will result in capital gains upon its disposition.
- As an example: If Mary purchases land for $500,000 and it is now worth $1,000,000. Though Mary has made unrealized gains of $500,000 she can transfer the property to a corporation at its cost of 500,000.
- Goodwill: As your sole proprietorship or company grows, so do your relationships and reputation; as a result, you have likely created an account of goodwill. Should you incorporate, the sole proprietor will have to transfer the goodwill from the sole proprietorship to the new corporation as it is a line item on the balance sheet. Using a Section 85 Rollover is one of the only ways that goodwill can be exchanged between companies. Some sources of goodwill include subscribers to service/ newsletter, Customer Lists that are relationships that are tied to the organization, patents, trademarks, copyrights and web content that generates revenue.
- Inventory: This typically includes assets that have increased in value from their initial purchase amount.
When do you have to file an election?
Now that you are excited to start rolling assets over, it is time to tackle how the rollover timeline works. The election must be filed before both you or your corporation’s tax return due date for the year in which the transfer took place. Any late filing within 3 years of that day is permitted, however, it can be subject to penalties. If you have missed this 3 year period you may still be able to file late if the Canada Revenue Agency (CRA) is of the opinion that it would be “Just and Equitable” to allow the late filing, late penalties will still apply in this case.
We understand that you think a rollover is the tax break you have been looking for and despite how flexible the Rollover 85 policy sounds, it still has downsides. Should you decide to claim a portion of capital gains through the process of rolling over there exists a possibility for double taxation. When the asset is “purchased” by the corporation you are an owner of, you can get taxed on both the purchase and on the capital gains.
Rollover 85 in a nutshell
A section 85 rollover is typically used to help a sole proprietor transfer ownership to a corporation while maintaining an ownership stake without incurring taxes during the “sale” of the assets or transfer of goodwill. It is also important to point out that goodwill is not a sellable or tangible asset, the section 85 rollover is one of the only ways to transfer the value of goodwill to another legal entity.
Section 86 Estate Freeze
Now we get to the real exciting part of the article; the estate freeze. An estate freeze is to set the value of growing assets or shares of a company at their current fair market value. This means that future growth in the value of these assets/equity accrues to the next generation. To summarize, this means that the value of an asset’s future growth will not be taxed while it remains owned by the current shareholder; taxation will only occur at the time of sale or their death. This will allow the proportionate capital gains tax obligation to fall on their successors.
To do this, the shareholder must force the corporation to undertake a capital reorganization; this means that ownership changes hands. The current shareholder (Owner), who in this case is also the freezor, will give up all of their common shares to the business in return for preferred shares. These shares allow the freezor to freeze their value of shares at a fixed value. During this process, they will also generate a new set of common shares that will reflect the continued and future growth of the corporation and its fair market value. These shares are distributed to the companies successors (Often these successors are also the to-be inheritors of the frozen shares) and may be held into perpetuity while appreciating from the continued and future growth. The significance of a freeze is displayed in the example below.
Let’s say Jamie owns a company and is thinking of retiring soon. The value of the company has grown since its inception and is currently worth $1,000,000. Now let’s also make the assumption that in 10 years it will be worth $10,000,000. Jamie, the freezor, has decided to freeze the value of the company at $1,000,000. The new owners of the business are awarded common shares at $0 in value. Should the freezor die after the business value has appreciated its $10,000,000 valuation, the inheritors will only have to pay the gains tax on $1,000,000 instead of the current value of $10,000,000. This also means that as long as the successors continue to hold the shares that have appreciated they will not be taxed. For reference the new common shares would be valued at $9,000,000, the preferred shares would be valued at $1,000,000 giving the total value of the corporation $10,000,000.
It is situations like this where a freeze can provide immense preservation of wealth. There have been situations in which an unfrozen estate was transferred to its successors when the original owner died, thus triggering a gains tax. In some circumstances the tax was higher than the liquidity of the successors, forcing them to sell the business or its assets hence discontinuing operations.
Why are these two related?
The reason that 85 and 86 are so closely related is that 85 is often used to roll over a property into a company on a tax-deferred basis using section 85 which can then be frozen using section 86. This way, should the freezor die, the tax burden is significantly lower and the successors are in a position to assume control of the business and all of its assets while continuing to hold all appreciated value between the time of freeze and the freezors death.