My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, June 27, 2016

What Small Business Owners Need to Know - Section 85 Rollovers

Section 85 of the Income Tax Act ("Act") provides for the transfer of certain assets with inherent tax liabilities to a corporation on a tax-deferred basis. Thus, accountants often utilize this section of the Act, to meet many of the objectives small business owners have.

Section 85 is most commonly used as follows:

1. Incorporation of a business – A sole proprietor has decided that their business is growing and ready for the next stage (incorporation). They can transfer all of their business assets to the new corporation under section 85.

2. Sale of a proprietorship – Section 85 helps sole proprietors looking to sell their business utilize the capital gains exemption by providing under certain circumstances for the transfer of their assets to a new corporation in exchange for shares; and those new shares are sold shortly thereafter. The typical 24-month holding period requirement for the use of the capital gains exemption will typically not apply in this situation (this is technical and your accountant should be consulted to ensure all criteria are met).

3. Crystallization of capital gains – A small business owner can make use of the capital gains exemption by using section 85 to transfer their current shares back to their corporation in exchange for new shares redeemable at a higher value – usually up to the maximum capital gains exemption available. For 2016, the exemption is $824,117 which is indexed annually. See this this blog post on the complexities of accessing the capital gains exemption.

4. Estate planning and income-splitting – Section 85 can help transfer an individual’s business to a future generation and allow the growth of the business to accrue to the new generation also allowing for dividend sprinkling. However the attribution rules and “kiddie tax” should also be considered when dealing with minor children.

5. Asset Protection – Section 85 allows small business owners to transfer assets usually land and building used in their active business out of their operating company to a holding company on a tax-deferred basis.

Some Technical Details


Section 85 is a valuable tool for corporate transfers because of the flexibility provided by a tax attribute known as the elected amount (“EA”). The parties involved in the transaction (typically the small business owner personally and corporation they own) can choose within limits, what the EA is and that becomes the deemed proceeds of disposition of the selected assets. Thus, in most transactions the parties elect the EA to be the adjusted cost base of the asset being transferred and thus, there is no gain, since the EA is the same as the cost. For example: if you have an asset with a cost base of $100 and a fair market value of $100,000, you could elect at $100 to avoid any adverse tax consequences.

If you elect a higher EA than the adjusted cost base, a capital gain will result. In cases where a small business owner wants to “crystalize” their capital gains exemption, they will often elect to trigger a gain equal to their capital gains exemption to bump-up their cost base of their shares and thus the small business owner pays no tax as their capital gains exemption eliminates the capital gain, however, alternative minimum tax may sometimes apply.

In order for subsection 85(1) to apply, both the taxpayer and the corporation must jointly elect in prescribed form T2057 – Election on disposition of property by a taxpayer to a taxable Canadian Corporation. There are various administrative matters that need to be considered when filing this election.

Section 85 is probably one of the most powerful and most utilized tax planning tools for tax practitioners. Therefore careful planning should be undertaken. When planning to utilize section 85 rollover, the below factors should be considered or adverse tax consequences could apply!

1. What types of property can be transferred? Attention needs to be taken when determining what types of property to transfer under section 85. The most commonly mistaken property that cannot be transferred is real property held as inventory i.e. land and building (Note: most people hold their real estate as capital property and not inventory). However other planning can be achieved to rollover real property held as inventory to a corporation on a tax deferred basis.

2. Should you transfer accounts receivable under section 85(1)? Other provisions of the Act should be considered to allow for the most tax efficient rollover of A/R.

3. What type of property can be received for transferring assets to the corporation? Can you receive cash or a promissory note in return without triggering punitive income tax consequences?

4. Do you have to receive shares in return for the assets being transferred? Can you receive a fraction of a share?

5. What type of corporation can you transfer the assets to on a tax deferred basis? Can it be a non-resident corporation or non-resident individual?

6. Determining the amount to elect if intellectual property is being transferred (i.e. goodwill)?

Once the assets are transferred to the corporation, there is no mirror provision available to roll them back out. It is generally advisable to include a price adjustment clause in case CRA does not agree with the estimated FMV of the property transferred (it is recommended that a valuation be undertaken to support the fair market value). The CRA recently published an Income Tax Folio: S4-F3-C1 – Price Adjustment Clauses that deal with the various types of situation in which a price adjustment should be included.

Other items to remember include GST/HST. Usually this tax will apply to the transfer price or the FMV of the assets. However an election can often be made which would allow the transfer of the assets to be exempt from GST/HST if certain conditions are met.

Section 85 is a very powerful provision of the Act and must be used with care. All of the above questions should be considered prior to commencing a rollover. There are other issues not mentioned above due to complexity. Always consult a tax specialist when dealing with rollovers.

[Thanks to Lorenzo Bonanno of BDO Canada LLP, for his assistance with this blog post]

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

Small Business Owners - Get on my Mailing List


If you are an owner-manager and/or a shareholder in a corporation and have not signed up for my corporate mailing list, please email me at bluntbeancounter@gmail.com

I will be sending out specific mailings on matters of importance to small business owners and I am considering, depending upon the interest, holding a roundtable for small business owners who are in the Toronto area. [I have not yet sent out a mailing, as I have been busy with December 31st corporate year-ends due June 30th. I will for sure send out something this summer].

Monday, June 20, 2016

Life Insurance - Review Your Coverage

Many of us purchase life insurance between the ages of 30 and 40 and subsequently pay no further attention to our life insurance needs. Today, I have a simple objective: to encourage you to review your current coverage.

Ask yourself this question. Has there been a change in your personal circumstances since you last purchased life insurance? If the answer is yes, now is the time to ensure you have sufficient coverage.

We hate paying life insurance for two reasons:

1. It forces us to accept our mortality.

2. As we age, the cost of life insurance becomes prohibitive, so most people who are lucky enough to live a full life, let it lapse (especially in the case of term insurance) and thus, have paid substantial sums of money for no monetary return (although, I think living is probably a fairly good non-monetary return).

Luckily, most of us get over these two hurdles and purchase life insurance to cover, amongst various things, the following:

1. Income replacement – life insurance acts as a replacement of income for the deceased person. This is very important where one spouse/partner is the breadwinner. The objective here is to allow your family to live in the manner they are accustomed to.

2. Financial security for dependents – somewhat related to #1, insurance ensures your spouse/partner is taken care of the rest of their life, and your dependants are financially covered until they are ready to join the workforce.

3. Mortgage protection - insurance pays off the family’s largest debt, typically the mortgage on their home.

4. Funding of University - many parents want to ensure their children are educated and use insurance to backstop that goal, in case they were to pass away.

Your Life Insurance Coverage Check-up


You may wish to review the following items or issues, to ensure your current life insurance coverage is up-to-date:

1. Your current salary or self-employment income – review your income. Has it changed significantly since you put your initial life insurance in place? If the answer is yes, and you are like most people in that your monthly family spending has expanded in proportion to your higher income, you will need more insurance to replace that income and increased family spending.

2. Life Expectancy – life expectancy continues to increase. In Canada, the average female is expected to live to about 84 and the average male to about 80. There is approximately a 25% chance one spouse/partner will live to the age of 95. The question for you is: what assumptions did you make about life expectancy when determining your life insurance needs for you and your spouse/partner/family? You may want to revisit those assumptions.

3. Debts – review your current debt load. Has your mortgage increased or decreased? Have you tapped into your Line of Credit for home renovations or investment purposes? Have you incurred any new personal debt?

4. University – many children attend university outside of Canada because the enrollment at many Canadian professional schools is very limited. Do you think your child(ren) may need to do such? If so, those costs could be 3-5 times higher than those of a child who studies in Canada.

5. Cottage – do you plan to leave the cottage to your children? You may want to ensure you and your spouse/partner have enough insurance to cover the taxes on the last of your deaths.

6. Estate Planning – some parents wish to use their insurance to leave a legacy to their children. If that is you plan, is your current insurance sufficient? If you are one of those parents, consider converting part of your term insurance to permanent insurance, if your policy allows such, or consider purchasing some new permanent insurance. If you have a private corporation, consider a corporate funded insurance policy as discussed in this blog post.

The above discussion is fairly simplistic. As noted, the main objective of this post is to have you review your current life insurance, to ensure it is sufficient for your current needs. If you determine your insurance is insufficient, make an appointment with your insurance advisor.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

Monday, June 13, 2016

The Income Tax Implications of Divorce Where You Own a Home and a Cottage

A few months ago, I was at a party when one of the party-goers started chatting to me about their
divorce. I ended up fielding various financial questions for which I referred them back to the matrimonial lawyer (I should have known they were not talking to me because of my bubbly personality).

But all was not lost. One of the questions they asked me about was the income tax implications of transferring their principal residence to their name, and the cottage to their spouse, as part of their divorce. As these transfers are often “messed up” and/or ignored in divorce agreements, I realized they had a least provided me a future blog topic. So today, I discuss the implications of transferring your home or cottage to your spouse upon divorce.

Principal Residence Exemption


In general, where you have lived in your home since its purchase, any gain upon the sale of that home is tax exempt because of the principal residence exemption (“PRE”). Where you own a house and cottage, things get more complicated, as you and your spouse may only designate one residence between you for purposes of the PRE, for each tax year after 1981 (prior to 1982, each spouse could designate one principal residence and thus you could possibly claim the PRE on both your home and cottage).

If you are happily married and own a home and cottage, in general, when you dispose of the properties, you would allocate the PRE to the property with the largest yearly capital gain. This calculation can be complex and typically leaves one property as taxable, or at least partially taxable (i.e. you may have owned your home 5 years before you purchased your cottage, so you have 5 years of PRE to claim on your home).

Where a couple is divorcing, how you allocate the PRE claim on your cottage and home is often problematic.

Spousal Rollover on Divorce


Unless you elect otherwise, where you transfer capital property, the Income Tax Act provides for a tax-free rollover to your former spouse if the transfer is in settlement of their property rights (transfers by title pursuant to a court order or provincial legislation also are provided for). In plain English, you can transfer, say a cottage, to your former spouse with no immediate income tax consequences, although, they assume the cost base of that cottage.

The Issue


One would think that based on the PRE and the tax-free spousal rollover, that where a divorcing couple has a home and cottage, things should be simple. However, since a couple can only claim one PRE during the marriage (other than when a spouse who was throughout the year living apart from and was separated under a judicial or written separation agreement) that is definitely not the case. This one PRE rule per couple is clearly noted in this interesting case, Balanko v The Queen.

Consequently, it is vital that the right to the PRE or the allocation of the PRE must be accounted for in any marriage settlement, for both purposes of the actual claim, and the related income tax one of the spouses may incur. If the use of the exemption is not addressed in the separation agreement, it is then a first-come, first-served claim.

In this article, the authors on page 1122 suggest that you consider at the time of separation or divorce that you complete a principal residence designation Form T2091.

Example


Say Tom and Katie are seeking a divorce and jointly own a family home (the home cost $300,000 and is now worth $1,000,000) and cottage (the cottage cost $500,000 and is now worth $1,000,000). In their divorce settlement, they agree that Tom will take the home and Katie the cottage (in real life, the house and cottage values and related income tax costs may be disproportionate and the value and tax discrepancy is equalized in some manner). This cross transfer of title can be done tax-free as discussed above; Tom assumes a cost base of $300,000 on the family home, and Katie a cost base of $500,000 on the cottage.

Katie has plans to sell the cottage immediately and to buy a new house. Katie’s lawyer and tax advisor decide to keep silent on the issue as to who can claim the PRE, since they know she will claim it first. Should Katie claim the PRE, Tom could be stuck with a tax liability approaching $175,000 when he eventually sells the home.

Luckily for Tom, he has hired sharp advisors. They raise the issues during the divorce negotiations. After some back and forth, the parties agree that Katie will claim the PRE; however, Tom is entitled to an extra $87,500 in family assets to equalize him for his future income tax liability.

If you and your spouse have a home and cottage and are unfortunately in divorce proceedings, or in a dissolving marriage, it is imperative your family lawyer and/or tax advisor consider/negotiate which spouse will be entitled to the PRE and whether a PR designation and/or tax equalization payment needs to be considered.

This blog post is for general information purposes only. The author is not a lawyer and the discussion above does not constitute legal or other professional advice or an opinion of any kind. The information above is provided solely to raise awareness of the issue. Readers are advised to seek specific legal advice regarding any specific legal issues.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.