Convert a Sole Proprietorship to a Corporation with a Section 85 Rollover

What converting a sole proprietorship to a corporation involves

Two separate steps, incorporating and transferring

The corporation is incorporated under the Business Corporations Act (Ontario) or the Canada Business Corporations Act. Then the business is sold to it under a written agreement. See Ontario incorporation under the Business Corporations Act.

Why the business does not simply carry on inside the new corporation

A corporation is a separate taxpayer. Until assets are transferred they remain yours, and income earned with them is still yours.

Should you incorporate at all

Our comparison of a sole proprietorship and a corporation sets out when the move pays, and when it does not.

The section 85 rollover, and when it is worth doing

What subsection 85(1) of the Income Tax Act does

It lets you and the corporation agree on a transfer price, called the elected amount, between your tax cost and the fair market value. The gain is deferred, not cancelled: the corporation inherits your tax cost and the deferred gain sits in the shares you receive.

Shares must be part of the payment

Subsection 85(1) applies only where the corporation gives you at least one share of its capital stock for the assets, so the articles need a class that can be issued for them.

Eligible property, and what cannot move

Capital property such as equipment and goodwill, and inventory other than real property, can roll over. Real property held as inventory cannot, and land and buildings also raise land transfer tax and legal questions.

The elected amount, the floor and the ceiling

The elected amount cannot be less than the cash and other non-share consideration you take back, and cannot exceed fair market value. For depreciable property it also cannot fall below the lowest of undepreciated capital cost, cost and fair market value.

When a rollover is not needed

A service business with a laptop and no goodwill worth arguing about often has nothing standing at a gain. It can transfer at fair market value with no election and no tax, and we tell you so rather than charge for a T2057.

Form T2057 and the election deadline

Why the deadline is the earliest of two dates

Under subsection 85(6), Form T2057 is due by the earliest day on which you or the corporation must file a tax return for the year of the transfer. For a sole proprietor that is usually 15 June of the next year, unless the corporation’s first T2 is due sooner.

Late filing within three years

Subsection 85(7) accepts an election filed up to three years late, with the estimated penalty paid when it is filed.

The penalty and the $8,000 ceiling

Under subsection 85(8), the penalty for each complete month late is the lesser of one quarter of 1% of the amount by which fair market value exceeds the elected amount, and $100, to a maximum of $8,000.

Beyond three years

Subsection 85(7.1) lets the Canada Revenue Agency accept a later or amended election only where it is just and equitable. That is discretionary, so it is not a second deadline.

Price adjustment clauses

If you take back more than you give up and the difference benefits a family member, paragraph 85(1)(e.2) can tax it. A price adjustment clause in the transfer agreement protects the elected amounts if fair market value is later challenged.

Goodwill and Class 14.1

What replaced eligible capital property

Since 1 January 2017, goodwill and the other former eligible capital property are depreciable property in Class 14.1.

The 5% rate and the 7% transitional rate

Class 14.1 is written down at 5% a year on a declining balance. Property that was in the old pool before 2017 gets 7% for tax years ending before 2027.

Valuing goodwill before the shares are issued

The value placed on goodwill drives the elected amount and the shares issued, so it is documented before the agreement is signed. A formal valuation by a Chartered Business Valuator is a separate engagement where a lender or a large figure calls for one.

Accounts receivable, inventory and the section 22 election

Why receivables are usually kept out of the rollover

A loss on receivables transferred under section 85 can end up as a capital loss, which is worth far less than an income deduction.

The joint election under section 22

Where all or substantially all of a business’s property is sold, you and the corporation can elect jointly so that the discount on the receivables is deductible to you and income to the corporation, which can then claim bad debts on them.

Inventory and work in progress

Inventory can roll over at its cost, so stock does not create income on the transfer.

HST, your business number and the section 167 election

Why the corporation needs its own business number

The corporation is a separate person, so it registers its own business number and GST/HST account. Your personal business number stays with you, and you close the program accounts the business no longer needs.

The $30,000 small supplier threshold

Registration is required once taxable sales pass $30,000 in a calendar quarter or over four consecutive quarters. Where the sole proprietorship was registered, the corporation registers at once so invoicing does not break. See our GST/HST registration guide.

The section 167 election and Form GST44

Where you sell all or substantially all of the business, which the Canada Revenue Agency generally reads as 90% or more of the assets needed to run it, you and the corporation can elect that no GST/HST applies to the transfer. The corporation files Form GST44 by the due date of its return for the first period in which tax would otherwise have been payable.

What the election does not cover

It does not cover services you will provide to the corporation, property leased or licensed to it, or a taxable sale of real property to a corporation that is not registered. Those are the usual reasons a filed election still produces an HST bill.

Telling customers, suppliers, the bank and the insurer

Contracts, leases and assignments

Contracts and leases do not move automatically, and many need the other party’s written consent. Assigning them is a legal step, and a lawyer should handle it.

Bank accounts, merchant accounts and direct debits

Payments must be collected in the corporation’s own bank account from the transfer date, or the income can be assessed to the wrong taxpayer.

Licences, permits, WSIB and insurance

Trade licences, municipal permits, WSIB accounts and insurance policies are reissued or endorsed in the corporate name.

Invoicing under the corporate name

From the transfer date, invoices go out under the corporation’s name and GST/HST number. If you used a registered business name, the corporation registers it for itself.

The year-end split between your final T1 and the first T2

The final period on your personal return

Business income up to the transfer date goes on your T1. Everything after it belongs to the corporation.

15 June filing, 30 April payment

Because you carried on a business, your T1 is due 15 June, but any balance owing is still due 30 April.

Choosing the corporation’s first year end

A fiscal period cannot exceed 53 weeks, so the first year is nearly always short. We choose it with you before the articles are filed.

The six-month T2 deadline and the payment date behind it

The T2 is due six months after year end. The tax is due two months after year end, or three months for a Canadian-controlled private corporation claiming the small business deduction.

Turnaround and registry stated times

Our preparation time

The asset schedule takes about 5 business days from complete records. The articles take 1 business day, and the transfer agreement and elections follow within days of the certificate.

Registry stated times

Ontario articles filed online are generally issued the same day. Corporations Canada states 1 business day for an online federal incorporation, or 4 hours with express service for an extra $100.00.

A deadline, not a processing time

Form T2057 is filed by a deadline. The date that matters is the subsection 85(6) date, so we work back from it.