Incorporating a sole proprietorship isn’t as straightforward or as tax-free as you may think. Before moving forward ensure you have all the crucial information.
Article Written for TaxWrx by Chartered Professional Accountant Jillian Battaglio.
This article highlights some of the things you will need to take into account when incorporating a sole-proprietorship.
It's a big decision with many potential tax-traps. Make sure you are well informed before taking the leap.
Step #1: Determine if Goodwill Exists
Changing a sole proprietorship into a corporation can trigger capital gains taxes personally.
This is because CRA deems you to have sold a business to yourself and charges you tax on the implied Goodwill.
Goodwill might exist in your business when:
It has grown rapidly and is very profitable
It has branding, logos, and a reputation outside of yourself as the business owner
It has loyal customers or long-term contracts that sustain it
It could survive if you as the owner were replaced
And it has a value over and above the value of any physical assets.
All of these are collectively known as Goodwill and can pop up when your sole-proprietorship has been successful.
Before moving forward with incorporation you’re going to want to sit down and do some soul searching to determine if your business has Goodwill.
This might mean reaching out to Chartered Professional Accountant and a valuation business expert.
A successful client had many of the factors listed above and suspected Goodwill of being present in their business.
They had grown rapidly, had great branding, and a steady customer following as well as a reputation separate from the business owner.
After pursuing a business valuation, it was determined that the company did not have any value beyond the physical assets because profits were relatively low.
This came as a bit of a surprise but it meant fewer taxes to consider upon incorporating and gave the business owner peace of mind.
Goodwill exists when you could sell your business for more than the value of the business's physical assets.
You can estimate a goodwill value for yourself but only a valuation expert can give you a dollar range that will stand up to CRA scrutiny.
Seeking a valuation is very expensive (often starting around $5,000) so you’ll want to carefully consider the Goodwill factors I listed earlier.
Not all businesses will have goodwill but it is something you’ll want to consider before proceeding with incorporation.
If you forgo this step, the CRA can come back many years after you’ve incorporated and determine a Goodwill value for you.
This could mean thousands of extra dollars in unpaid capital gains taxes and a very nasty surprise.
"If you forgo this step, the CRA can come back many years after you’ve incorporated and determine a Goodwill value for you." - Jillian Battaglio, CPA, CA
If you suspect Goodwill of existing in your business, please do your homework and due diligence before moving forward.
Step #2: Fair Value or Cost?
Next, you are going to want to determine the dollar values you will be moving your business’s assets into your corporation at.
Assets include things like equipment, machinery, computers, furniture, and vehicles, as well as intangibles like Goodwill.
You’ll need to sell these from your sole proprietorship to your corporation and pay any tax that arises.
You must sell your assets to your corporation at the fair market value unless you choose to use a tax roll-over election called a Section 85.
This is a surprise to many clients who assume the cost approach was available 'tax-free'.
Taxes arise when the current fair market value is higher than the cost (or the depreciated tax value) of your assets.
To determine your depreciated values, take a look at the asset schedule at the back of your T2125 Statement of Business Activities available on your annual Personal Income Tax Return.
If the gap is too big for comfort then consider using a Section 85 tax rollover election.
What this does is defer any tax consequences into the future and you’d pay for any change in value upon the eventual sale of your corporation.
A section 85 prepared by a Chartered Professional Accountant is also very expensive (often starting at $5,000) and for small businesses paying the tax may be the less expensive choice in the long run.
"You must sell your assets to your corporation at the fair market value unless you choose to use a tax roll-over election." - Jillian Battaglio, CPA, CA
If you don’t use a Section 85 and gift the assets to your corporation or move them over at anything other than the fair market value the CRA can reassess any values you transfer.
This can mean thousands of extra dollars in unpaid capital gains taxes and a very nasty surprise several years after incorporation.
Step #3: Estimating Fair Value and Goodwill
So how do you estimate fair market values?
I get this question time and time again from clients looking to incorporate their sole-proprietorships.
I’d recommend taking a look at auction sites or other used good retail sites to come up with an average fair market value based on similar items.
Be sure to consider your industry experience.
Ask yourself if the fair value you’ve determined makes sense given the condition of your equipment and your understanding of your industry.
For Goodwill, you can do something similar but proceed with caution.
Goodwill is complex and part art, part science. Start by looking for similar businesses for sale online.
These can be hard to find but are a great baseline.
Next, you may need to break out your calculator. A business valuation expert may use:
A profit multiplier
A revenue multiplier
Or just consider the asset if Goodwill isn’t suspected.
Again, use your industry experience to help evaluate if the number you are proposing is reasonable.
As you are estimating values please keep in mind that if a formal valuation or section 85 election isn’t done, the Canada Revenue Agency can always contest your ‘Fair Market Value’ and Goodwill amounts.
To help counteract this be sure to have lots of good documentation available for auditors.
This can mean leaving notes and memos to yourself on the approaches you took as well as screenshots and printouts of information you are reviewing online.
Step #4: Ask For Help
The topic today has been very complex and may be a bit outside of your comfort zone.
Don’t be afraid to ask for help and reach out to a Chartered Professional Accountant who can help you decide if a business valuation or Section 85 is a good idea for your business.
All right, that is all I have for today. I hope this article has helped you understand some of the things you will want to take into account when incorporating a successful sole-proprietorship.
If this topic has interested you, be sure to check out our other blog articles and consider subscribing to one of our membership plans so you can be a well-informed business owner.
Article Written for TaxWrx by Chartered Professional Accountant Jillian Battaglio.