Converting a Sole Proprietorship to a Corporation

Allan Madan, CA
 Sep 16, 2011
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Just in case this is the first post of mine you’re reading, a little introduction is called for. I’m Allan Madan, a chartered accountant and tax expert in the Mississauga and Toronto regions of Ontario, Canada. This article is about converting a sole proprietorship to a corporation.

If you’re a small business owner that’s unincorporated and you’re planning on forming a corporation soon it’s really important that you go through this article. Here, you’ll find out everything you need to know from a tax perspective. This article is broken down into five small parts.

Advantages of a Sole Proprietorship

While incorporating your business is generally much more beneficial, sole proprietorships do hold a few minor advantages.

The advantages all stems from its simplistic structure which in turns provides a few benefits:

  • The sole proprietor has full managerial control over their business and can control the business costs at an individual and micro-level
  • The owner does not have to file a separate tax return but rather includes their business income on their general T1 income tax return
  • You don’t have to register your business if you operate it under your own name.  If you have to register it, it is still significantly cheaper than registering a corporation
  • Ease of initial startup, administration and dissolution

Converting a Sole Proprietorship to a Corporation – Why?

So, why should you change to a corporation in the first place? There are three main reasons, and they are:

1. A corporation presents you with limited liability protection. What this means is that if you are sued then the only assets that are at risk in the lawsuit are the corporation’s assets, not your personal assets. On the other hand, if you remain with sole proprietorship, meaning you’re non-incorporated, and you get sued, your personal assets are at risk as well as your business assets. So, you could lose your home, your car, your investments, and so forth. This is something that you want to avoid altogether.

2. The second reason for changing into a corporation is the tax rate for a corporation is lower than the tax rate for an individual. The corporate tax rate combines the provincial and federal, and in the province of Ontario it’s only 15.5% for the first $500,000 of business profits. Business income, at the individual level, is taxed at marginal tax rates. The marginal tax rate at the top bracket in the province of Ontario is 46.4%. You can see that you will save approximately 31% if you incorporate. That’s 31% in taxes on your business income.

3. The third reason for changing into a corporation is with a corporation it’s a lot easier to split business income with your family members through the use of dividends.

Closing the Sole Proprietorship:

How do you close your sole proprietorship if you have one right now? Well, you have to do two things.
• You need to cancel your business registration with the Ontario Ministry of Governmental Services. If you live in another province, get in touch with the Ministry of Governmental Services, and similar procedures will apply.
• The second thing you need to do is contact the Canada Revenue Agency at 1-800-959-5525. Cancel your business number, HST number, and payroll number, if you have them, with the Canada Revenue Agency; and you should be able to do this over the phone.

Transferring of Assets:

The third thing we talk about is what assets are transferred from proprietorship to a corporation when you form your new corporation. Well, there are two categories of assets.

2. The second category in intangible assets; and you may not think about it but one of the biggest assets for your business is an intangible one, and that is goodwill. Goodwill, by definition, is what someone would pay for your business over the cost or price of the physical assets.  So it is simply viewed as the approximate value of a company’s brand names, reputation, or long-term relationships that cannot otherwise be represented financially.

The Value of the Goodwill

Since goodwill is an intangible asset, it is difficult to accurately quantify since it differs in its composition and varies from industry to industry and businesses.

Goodwill is the difference between the tangible assets and the purchase price.

The total value of any business can be described as the accumulative sum of its physical tangible assets plus the value of its goodwill.  So goodwill is essentially equal to the difference between the total value minus the standalone value of its tangible physical assets.

If a company is sold for $5 million, but only had $3 million in tangible physical assets then we would equate its goodwill to $2 million.

Some common goodwill items include: phantom assets, local economy, loyal customer base, reputation, supplier list, location, trademarks, name recognition, copyrights, trade secrets, industry ratios, royalty agreements, licenses, contracts, growing industry, and recession resistant industry.

Workplace Safety and Insurance Board (WSIB) Account

In most cases, your corporation should assume the liabilities and assets of your sole proprietorship when you transfer your assets.  Your previous WSIB account will also be assumed by your corporation.  If this is not the case, you will have to open up a new account.

The Section 85 Rollover:

It’s really important for you to get this right because this could save you a lot of money. When you are transferring assets from your proprietorship to your corporation, you should do so only under the provision of Section 85 of the Income Tax Act. You have to do this and you have to file the related Section 85 forms. By doing so, you will not have to pay any tax on the sale of your assets, both, physical and intangible, from your sole proprietorship to your corporation.

If you don’t file Section 85 rollover, either because you didn’t know, or because you didn’t want to go through the tough exercise of doing so, you’re in for a surprise. What will end up happening is that the CRA will reassess the transaction and bump up the sale price to the fair market value of the assets. Here’s an example.

If the assets that you own, including goodwill, are a hundred thousand dollars, and you paid only thirty thousand dollars for them, then the CRA will impose capital gains tax on the gain of seventy thousand dollars. This will happen only if you do not file an election pursuant to Section 85 of the Income Tax Act to transfer your assets from your sole proprietorship to your corporation.

Pitfalls to Avoid:

In converting a sole proprietorship to a corporation there are certain pitfalls you’d need to avoid. These pitfalls have come from mistakes I’ve seen others make and I’m going to share them here. The first main mistake I’ve seen people make is that they sell their assets for only a dollar; that is, they sell their business assets to their corporation for only $1. Now, if you are ready to sell your business assets to me for a dollar I’d readily buy them. The CRA does not like this and what they’ll do is reassess the sale price from one dollar to the fair market value (that’s what a third party would pay). As a result you end up paying capital gains tax on the difference between the fair market value of the assets transferred and what you paid for them.

The second major mistake that I’ve seen people make throughout my career is that they gift assets to the corporation they just formed. What this means is that are transferring the assets from their sole proprietorship to their new corporation without receiving any consideration like money or shares in return for the transfer. If you do that, once again, the CRA will step in, reassess the sale price from zero to what the fair market value of the assets is, and you will end up paying capital gains tax on the difference between the fair market value of the assets transferred and what you paid for them.

Here’s hoping that what you read here about converting a sole proprietorship to a corporation you found useful, and know that you can get more such advice for free just as long as you know where to look (and now you do).

Disclaimer

The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.

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Comments 54

  1. Great video and information. Too bad you did not touch on what you do with expenses incurred as the Sole Propriertor and how to handle them in your financials when you incorporate.
    Thanks for the info

    1. Hi,

      Thanks for your inquiry!

      The general overview is that your expenses remain largely unchanged. Two main differences are that for a corporation, you no longer report your revenues and expenses on the 2125 form of your T1 but instead on the T2 and you need to make sure invoices and bills are billed to the corporation and not to the individual. Of course there will always be more more complicated expenses such as life insurance and disability for corporations. If you would like a more in-depth analysis, you can always set up a consultation meeting with us as we would be more than happy to guide you.

      – The team at Madan CA

  2. Hello,

    Very useful video! What about the business name of the registered name of the sole proprietorship? Is that lost or could it also be transfered to the new corporation?

    Best,
    Wil

    1. Hi Wil,

      To answer your question, yes you may! However, if you want to incorporate federally, you will have to insure that your corporation’s name satisfies its eligibility criteria including ensuring that the same name is not used by another corporation already.

      Furthermore, there may be some formality requirements with the Industry Canada including a Consent Letter in which you consent your corporation to use the name of your sole proprietorship.

      Thank you,

      – Allan and his team

  3. Hi Allan,

    I’ve heard there are recent issues about incorporation and being labelled as a personal service business, can you elaborate on this issue, it would be much appreciated.

  4. HI Allan,

    When converting from a sole proprietorship to a corporation, can I claim costs + fees involved including re-obtaining licenses, permits, accounting fees, new bank accounts?

    1. Hi Thompson,

      These fees are all related to your business expense and therefore are tax deductibles.

      Best Regards,

      Allan Madan and Team

    1. Hi Chrissy,

      The best option would be to file two separate business tax returns for each entity, since they are legally two different ones and not simply a continuation of the existing one. You would be able to write off business expenses incurred while operating each entity.

      Best Regards,

      Allan Madan and Team

    1. Hi Cruz,

      You actually can’t pay yourself dividends if you are a sole proprietorship. That’s why incorporating your business is so beneficial because you are allowed to pay dividends which are taxed at lower rates.

      Best Regards,

      Allan Madan and Team

    1. Hi J.J.,

      Yes this is correct. The LCGE is increasing from $750,000 to $800,000 starting this year. In addition, to ensure that the real value of the LCGE is not eroded over time, Economic Action Plan 2013 proposes to index the $800,000 LCGE limit to inflation for the first time ever. The first indexation adjustment will occur for the 2015 taxation year.

      Best Regards,

      Allan Madan and Team

        1. Hi Timothy,

          While I don’t know the specifications for the indexing, I would generally assume that it would be indexed based on the national inflation rate in Canada.

          Best Regards,

          Allan Madan and Team

    1. Hi Lyle,

      The process for this would be the same as if you sold property to the corporation in return for cash. The only difference is for your newly incorporated company, you have to structure your shares so that you can issue them in exchange for property. Also the difference between the stock value received and the tax basis in the property transferred to the corporation will result in a gain or loss.

    1. Hi Arielle,

      There is no single answer, the best structure would be dependent on a variety of different factors including type of corporation, number of expected owners/shareholders, different liability protections etc. If you could provide me with some more information.

      Best Regards,

      Allan Madan and Team

  5. I am thinking of selling my business, I need some guidance with regards to how to calculate the good will amount. Is there a certain percentage I am eligible for?

    1. Hi Jason,
      Thank you for your question. A simple way to determine the good will is to calculate the fair market value of ALL tangible assets and subtract this value from the sale value of the company. This will give you the value of good will. There is no specific percentage to calculate the goodwill.
      Best Regards,
      Madanca Team.

    1. Hi Nate,

      You don’t need a separate or different tax return to report your business income. You can report your worldwide total income on the T1 and then if you have several different businesses or employment income etc., it all gets report on the same tax return.

      Your business income is reported on the form T2125.

  6. I am a photographer, videographer, and graphic designer. I want to register my business, but I’m not sure if I should do so as a sole proprietorship or a corporation. I am just starting off, so my loss is bigger than my gain. If I register my business, would I be able to write off camera equipment and other business expenses?

    1. Hello Rita.

      Based on your situation, I would not recommend incorporating your business right now. Incorporating your business can be costly, both in starting and maintaining it. There is also inherent paperwork that is related to incorporating. However, you can register your business for free. You camera would be considered a capital expense, and would need to be depreciated with capital cost allowance. Depending what you are claiming, your equipment will have a different class and will be depreciable at a different rate. For more information, please visit http://www.cra-arc.gc.ca/tx/bsnss/tpcs/slprtnr/rprtng/cptl/dprcbl-eng.html
      Though the CRA doesn’t expect your business to make money right away, you should have some reasonable expectation of profit in order to claim a loss. Best of luck on your new business. If you have any questions, please don’t hesitate to contact me.

      Regards,
      Allan Madan and Team

  7. I have a truck that i use for both my sole proprietorship construction business and personal use. I make bi-weekly payments on it.
    I am considering incorporating. If i transfer the truck to the corporation can my truck payments be deducted from the corporate account? Thanks

    1. Hi Ray,

      In order to deduct the cost of leases and operating expenses in the corporation, the truck must be owned legally by the corporation. The transfer of title may trigger sales tax.
      If the corporation obtains title of the truck, then the corporation will be able to deduct its portion of the expenses. Say you use the truck 80% of the time for business purposes, and 20% for person, then you should prorate your total truck expenses 80-20 between the business and you personally. The personal portion is not deductible anywhere.

  8. Hi Allan. Great article here, extremely insightful.

    I have a question about transitioning. If there are unpaid accounts still under the sole proprietorship, can it still be closed in order to start the incorporation process? What happens when those invoices get paid eventually?

    Merry Christmas,

    Thanks,
    Jae

    1. Hi Jae,

      Thanks for your question. You have two options in dealing with the existing accounts receivable (A/R) and accounts payable (A/P).

      1. Transfer the existing A/P and A/R to your newly created corporation, by way of promissory note. Then, have your sole proprietorship continue to pay the outstanding bills, collect the receivables, and remit the net proceeds (difference between collections and bill payments) to your corporation. From a tax and legal perspective, the A/P and A/R belong to the corporation, even though the sole proprietorship is handling the payments. [A section 22 Election should be prepared in respect of the A/R transferred].

      2. Do not transfer the existing A/P and A/R to your newly created corporation. The sole proprietorship will collect customer balances owing, and pay bills. From a tax and legal perspective, the A/P and A/R belongs to the sole proprietorship.

      Whether you choose option 1 or 2, the sole proprietorship’s bank account must remain active to clear out old balances.

  9. Hi Allan,
    I am a Canadian left to the Gulf to work there. I do not intend to come back to live in Canada. I do not have any ties in Canada (closed my bank account, have no driving licence, have no home, have no personal belongings, no social ties, …etc). Actually, the only tie I have is my Canadian passport.
    Also, my wife (64 years old) did not decide yet whether to come with me or stay with her son (who is 35 years old, lives and works in Canada).
    My question is: am I considered none-resident?
    What if my wife decided to stay in Canada?
    Can I transfer some money every once in a while to her to help her continue living in Canada as she wanted?
    Appreciate your response.
    Jay

    1. Hi Jay,

      Factual resident – It is observed that you have significant social ties to Canada by having your wife in Canada and also willing to support her by sending the money. Hence you need to report income from Canadian and worldwide sources from the day you depart and file tax returns to Canada.

      Determining Residency Status: File NR73 Form – to determine residency status

      After determining Residency Status: If you are still considered as resident for tax purposes in Canada, the following information will be helpful for you.

      You will need to be more specific about the area you are currently living. If you are residing within a country where Canada is already established a tax treaty (such as U.K.) you may be allowed Foreign Tax Credit for the taxes that you paid in the tax treaty country.

      Transferring money: Speak to someone at the bank for transferring money earned abroad – Financial entities are required to report electronic funds transfers over a limit.

      Residency Status Link: http://www.cra-arc.gc.ca/tx/nnrsdnts/cmmn/rsdncy-eng.html

      Best Regards,

  10. I’m handling the book for the sole proprietorship, I want to convert to LLC, how do I make the complete accounting entries for the closing of proprietorship and opening the LLC?

    1. Hi Eric,

      LLC’s (limited liability company) are for Americans. If a LLC is used by a Canadian to conduct a business, double tax will result (by IRS and by CRA). A better alternative is to transfer the sole proprietor’s assets (tangible and intangible) to a Canadian corporation pursuant to Section 85 of the Income Tax Act. This way, capital gains tax will not result on the transfer. Double taxation will also be avoided.

      Best Regards

  11. Me and my husband incorporated the business and he has 100% of voting shares class A and I have 100% of voting class B. I did not transfer anything from his proprietorship yet as I don’t know where to start. We don’t have much assets and most expensive assets like car and some tools were purchased just recently under the old structure. What should be my next step? Can I issue more shares in exchange for the assets and put some cash in thee corporation in exchange for the promissory note? How do I do it so we don’t get hit with the taxes? Thanks!

    1. Hi Anna,

      Thanks for your question. For assets that have declined in value since your husband bought them (e.g. office furniture, equipment, computers, etc.), he can transfer those assets to his newly formed corporation in exchange for a promissory note. The exchange amount (i.e. selling price) should be equal to the market value of the assets on the date of transfer.

      For assets that have gone up in value (e.g. goodwill or customer list), they should be transferred to the corporation pursuant to Section 85 of the income tax act. This can be accomplished by completing form T2057 along with a transfer agreement, which my office can prepare. Otherwise, capital gains tax will result on the transfer.

  12. I am renting a resaurant location ,I am not sure if it is the best to have opened corperate business account or as right now the business is sole.I did so much expenses for renovation and equipment for that location about 80.000$. Basically the question is if it is better for restaurant to have corporate or sole.I am reading all the question and your answers,in some point I do not understand at all. Please help and reply.

    1. Hi Heda,

      Thanks for your question. You can protect your personal assets from being exposed in a business lawsuit if you are incorporated. With a sole proprietorship, your personal assets are at risk of loss.

      Additionally, corporation’s pay a low tax rate on business profits (15% in the Province of Ontario on business profits up to $500,000).

  13. HI, I have a question similar to Anna’s. I changed from a sole proprietorship to a corporation. How and when should I use a promissory note for transferring some home office furniture and a computer. Or is it easier to just include remaining values as a capital gain from the old business? There is no other goodwill.

    Thanks

    1. Hi Phil,

      You are supposed to sell your sole proprietorship’s assets at their current market value to your corporation. Since furniture and computers don’t appreciate in value, it’s fair to assume that their current market value is equal to their Undepreciated Capital Cost (UCC). For example, assume that the UCC of your computer is $500 and the UCC of your furniture is $750. To avoid a recapture of previously claimed CCA, consider selling the computer and furniture to your corporation in exchange for two promissory notes for $500 to $750 respectively.

  14. Hi,
    Thanks for the info. It was very informative. I’ve registered my business as a Sole Proprietorship. I’m doing this all on my own and I found out after that I cannot register a trade name unless I’m incorporated. I still plan to keep my sole proprietorship now, but when time comes and I want to incorporate, will I lose my business name?? or can I transfer and use the same business name for my corporation and finally register a trade name?
    Please help! What other options do I have ?

    1. Thanks for your question Yzabelle,
      You can register a trade name for a sole proprietorship with the Ministry of Government Services in your province. If you incorporate a company, you can have the same name for your company as you had for your sole proprietorship, so long as nobody else has taken it.

  15. Great video Alan. Curious about a case where converting a sole prop into a newly formed corporation, the owner transfers assets like laptop, inventory & equipment to a corp. However, assets were never capitalized (so no CCA claims) or written off while self-employed. Fair value of the assets is say $5K, is a section 85 rollover required in this case (no real gain to defer), with shares being issued, or would you just record this transaction through a shareholder loan? Thanks!

    1. Hi Matt,

      You can transfer these assets outside of Section 85 because there is no taxable capital gain to defer. Record a shareholder payable for $5,000 and assets for $5,000 on the company’s financial statements.

  16. I have a situation where old Corp is transferring assets to a newly formed Corp. The owner of both Corps is same and therefore related. I elect under 85 to rollover Automobiles from Old Corp to New one at UCC.
    Where should I show the transfers on the T2 return of old Corp? When UCC is booked in the new Corp, how it will recapture CCA when sold in the future?
    Thanks

    1. Hi Abdus,

      Record the proceeds of disposition on Schedule 8 of the transferor corporation. Record the acquisition cost on Schedule 8 of the receiving corporation. In both cases, the transfer price is equal to the UCC. Also complete Schedule 11. When the receiving corporation eventually sells the property, either a terminal loss (selling price less than UCC) or recapture (selling price more than UCC) will be recognized.

  17. Hi Allan,

    Would transferring a partnership to a corporation (owned by the same two) be the same as from sole proprietorship to corporation?

    Also, to take advantage of home office and car use deductions, is it possible that after such transfer, I establish a separate sole proprietor entity and have the corporation contract its CEO/Director position to my SP company?

    Thanks for the immensely helpful article.

    1. Hi Ivan,

      The tax free-rollover rules for a sole proprietorship are very similar to those for a partnership. In both cases, assets can be transferred on a tax-free basis to a corporation.

      Do not create a sole proprietorship for the purpose of taking advantage of car and home office deductions. The payments made by the corporation to your sole proprietorship will likely be considered as employment income. Instead, charge back your home office expenses to your corporation, and consider receiving a tax-free vehicle allowance from your corporation.

  18. “Hi,
    I operated a sole proprietorship which incurred a loss since its inception. I have closed the sole proprietorship
    business and transferred it to a company(ltd) offering the same services. What do I do with the loss that was being carried forward since opening? Please advise.

    Thank you

  19. Hi,
    I registered my business name under sole proprietorship about 2 weeks ago, and have not done anything (no business number, cra accounts, sales, profit, bank accounts, etc). I have just decided to incorporate the business. I cancelled the masters business license today and plan to incorporate this coming week. Do I have to do any tax filing in January for the 2-week period of having the masters business license eventhough nothing happened after registering the business name? If so, what do I have to file since there’s no seperate accounts? Also, when incorporating, the name that I just cancelled today is showing up on the NUANS report. I plan to use the same name when I incorporate. Does it matter if its still showing up on the report since its my own? Thanks a lot!

    1. Hi Christine,

      You should complete form T2125, Statement of Business Activities, and attach this form with your personal tax return. On this form, indicate the start date and end date of the business.

      You can register a corporation with the same name as your sole proprietorship. Please let me know if you need my assistance with incorporating and preparing a corporate minute book.

  20. Hi Allan,
    Great article! I am in a very unique situation. I would really appreciate your comments on it. I moved from USA to Canada in August 2016. I am not a US citizen or Greencard holder though, was in USA on H-1B work visa. I am a Canadian permanent resident now and live in Vancouver, British Columbia. I am planning to start my business on Amazon USA website selling physical products and purchase products from suppliers in USA using my US credit cards only as I will be part of double exchange rate if I use my Canadian credit cards. Per my research online I came to know that starting off as a corporation right away will provide liability protection but I will be paying lot more in business filing fees so I am thinking to start off a Sole Proprietorship for now. Below are my 2 questions with regards to this scenario:
    (1)How much revenue should I be making (more than USD $10,000 per month?) in order to justify Incorporating in BC rather operating as a sole proprietorship?
    (2) If I operate as a sole proprietorship,lets say, from January 10,2017 to June 1,2017 and then incorporate from June 1,2017 to December 1,2017 then will it be a lot of work and hassle to file 2 different tax returns to CRA by February 2018 per the norm?
    (3) If I am selling,lets say, 1 product in each category (Home,Kitchen and Pet Food products) of Amazon USA website as a Sole Proprietorship from January 10,2017 to June 1,2017 and based on the high monthly revenue decide to incorporate in BC, then do I have to go through the whole process of getting EIN from IRS again and re-branding as a Corporation on Amazon USA website or can I still keep the brand name I used as a Sole Proprietorship? Is it recommend that I incorporate right away to save myself from tax headaches and liability protection in future?
    I would really appreciate your comments! Thank you!

    1. Hi Sanjay,

      1) You should incorporate your business when you are making more money than you need to pay for your business and personal expenses. In other words, incorporating a business makes sense when you have the ability to save your earnings and not spend it all. The money saved within a corporate bank account is NOT subject to personal taxation.
      2) It will be a bit more work if you incorporate your business midway through the year. But it’s doable.
      3) A corporation must have a separate legal name and EIN. Incorporating now will save you time since you only have to register once.

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