Section 85 Rollover: Tax-Deferred Transfers to a Corporation

Most owner-managers reach a point where appreciated property — an operating business, a portfolio of shares, real estate, goodwill that has quietly grown over a decade — needs to move into a corporation. The obstacle is that a transfer to a corporation is, by default, a disposition at fair market value. Moving a property worth $2 million that cost $200,000 would ordinarily realize a $1.8 million capital gain and a tax bill to match, all without a dollar of cash changing hands. Section 85 of the Income Tax Act exists precisely to remove that obstacle.

What section 85 actually does

Section 85 permits a taxpayer to transfer eligible property to a taxable Canadian corporation in exchange for shares — and optionally other consideration — at a jointly elected amount that can defer the disposition for income-tax purposes. The election is filed on Form T2057 (or Form T2058 for transfers by a partnership). In plain terms, the transferor and the corporation agree on a number, and that number becomes both the transferor's proceeds of disposition and the corporation's cost of the property. Choose the number well and the transfer happens with little or no tax today.

The mechanics break down into four moving parts:

• The transferor — an individual, corporation, trust, or partnership in narrow circumstances — transfers eligible property to a taxable Canadian corporation.
• The corporation issues at least one share to the transferor as consideration. It may also issue non-share consideration, known as "boot" — most often a promissory note.
• The two parties jointly elect under subsection 85(1) on Form T2057, specifying an elected amount for each property.
• The elected amount is deemed to be the transferor's proceeds and the corporation's cost.

When section 85 is the right tool

The rollover is a building block, not a destination. It tends to appear in a handful of recurring situations:

• Incorporating an existing business. A sole proprietor transfers business assets — goodwill, equipment, inventory, accounts receivable, intellectual property — into a new corporation in exchange for shares, often with a promissory note for boot. The accrued value built up while operating personally rolls into the corporation without an immediate tax hit.
• Inserting a holding company. Operating-company shares are transferred to a new holdco in exchange for holdco shares, separating the active business from accumulated retained earnings and creating room for future creditor protection, capital extraction, and reorganization.
• Estate freezes. Existing common shares are exchanged for fixed-value preferred shares, capping the freezor's value at today's fair market value while new common (growth) shares are issued to a family trust or the next generation. We cover this in detail in our companion guide on estate-freeze mechanics.
• Crystallizing the lifetime capital gains exemption. Triggering the LCGE today against qualified small business corporation shares locks in the exemption at current values and steps up the adjusted cost base.
• Purifying a corporation before a sale. Removing non-active assets from an operating company before sale, so the shares qualify for the LCGE, frequently runs through a section 85 transfer to a holdco.

Eligible property — and what is excluded

Most property used in a Canadian business is eligible for a section 85 rollover. That includes capital property (both depreciable and non-depreciable), inventory, Class 14.1 depreciable property (the successor to eligible capital property, which captures goodwill), Canadian and foreign resource property in defined circumstances, real property in defined circumstances, and shares of one corporation transferred to another. The common exclusions are real property held as inventory by a non-resident and certain property where the transferor is a non-resident. Eligibility is fact-specific, and where there is any doubt it should be confirmed before the structure is built — an ineligible property dropped into a rollover does not roll.

The elected amount: the most important number

The elected amount determines the transferor's deemed proceeds, the corporation's deemed cost, any capital gain or loss triggered on the transfer, and the cost base that carries forward inside the corporation. It is the single number most worth getting right, and it must fall within statutory limits:

• It generally cannot be less than the cost amount of the property. For non-depreciable capital property, cost amount is generally the adjusted cost base. For depreciable property, it is generally the lesser of undepreciated capital cost and capital cost. For inventory and accounts receivable, it is generally the cost or face value.
• It generally cannot be greater than the fair market value of the property.
• It cannot be less than the fair market value of any boot received, subject to the specific rules in paragraph 85(1)(b).

Within those bands, the elected amount is a planning lever. For a clean tax-deferred rollover that triggers no gain, the elected amount is usually set at the cost amount. For an LCGE crystallization, it is set at fair market value so the gain is triggered and then sheltered by the exemption. Intermediate amounts allow partial-tax structures where some gain is realized deliberately — for example, to use up expiring loss carryforwards.

Share consideration and boot

The corporation must issue at least one share. The class of that share matters enormously. Common shares participate in growth above their value and can be voting or non-voting. Preferred shares carry a fixed value (usually equal to a redemption price), priority on dividends and liquidation, and a retraction right, but do not participate in future growth — which is exactly why they are the workhorse of an estate freeze. A preferred share without a fixed redemption value, a retraction right, and proper ranking does not freeze anything, so the share terms in the articles have to be drafted with care.

Boot is non-share consideration, typically a promissory note. It does useful work: it gives the transferor a tax-paid extraction path (the note can be repaid as a return of capital), and it sets the cost of the consideration shares at the elected amount minus the boot. But boot is also a trap. If the value of the boot exceeds the elected amount, the excess is treated as proceeds in the year of transfer and the deferral is defeated to that extent. The note's terms — demand or term, interest-bearing or not, secured or unsecured — affect its fair market value characterization and the downstream tax treatment, and should be designed alongside the rest of the plan rather than papered in afterward.

Paid-up capital and stated capital

The corporation's stated capital — a corporate-law concept under the OBCA, the CBCA, or the governing statute — must be set correctly for the consideration shares, and the tax paid-up capital is then computed under subsection 85(2.1). Where the stated capital would otherwise exceed the section 85 limit (broadly, the elected amount minus boot), subsection 85(2.1) automatically grinds the tax PUC down. The grind is automatic for tax purposes, but it must be recorded accurately in the corporate accounting. PUC determines how much can later be returned to shareholders without triggering a deemed dividend under section 84, so an inaccurate PUC figure surfaces as a nasty surprise on a future redemption, return of capital, or wind-up — sometimes years later.

The T2057 election

Form T2057 is the joint election. It is signed by both the transferor and the corporation, and it must be filed by the earliest of the parties' filing deadlines for the year of the transfer. It sets out each property, its description, the elected amount, the consideration breakdown, and the fair market value. A late election is available within three years of the original due date, subject to penalty; beyond three years it depends on the Minister's discretion under subsection 85(7.1). Amended elections are possible within a finite window under the same subsection.

The most common T2057 problems are mundane and entirely preventable: elected amounts that do not match the transfer agreement, property descriptions that do not match the transfer, boot that exceeds the elected amount, missing signatures, and late filing. The election has to align with every other document in the file — the transfer agreement, the share certificates, the resolutions, and the accounting. Inconsistencies among those documents are the classic audit trigger.

Where rollovers go wrong

In practice, defective rollovers tend to share a short list of recurring faults: boot that exceeds the elected amount; share consideration whose value does not equal the property's value minus the boot (which can produce a deemed gift under paragraph 85(1)(e.2) and section 15 or section 246 issues); the wrong share class; articles of incorporation that do not actually authorize the class of shares being issued (the corporation must amend its articles before issuing the shares, not after); stated capital that does not match the section 85 limit; promissory-note terms that distort the transaction; and inconsistent resolutions, registers, and minute-book entries. A rollover where the T2057 says one thing and the transfer agreement says another is, in substance, a defective rollover regardless of how well the tax arithmetic was done.

A worked example: incorporating a proprietorship

Consider a consultant who has run an unincorporated practice for years and now wants to incorporate, both for the small-business tax rate on retained earnings and for the option of a future sale. The practice has accounts receivable of $80,000, equipment with an undepreciated capital cost of $15,000, and goodwill the consultant believes is worth $300,000 but which cost nothing to build. Transferring those assets to a new corporation at fair market value would realize income on the receivables, recapture on the equipment, and a gain on the goodwill — a meaningful tax bill in a year when the consultant has only just incorporated and has no cash to pay it.

Run through section 85, the same transfer can be done with little or no immediate tax. The receivables and equipment are elected at their cost amounts, so no income or recapture arises. The goodwill — Class 14.1 property — is elected at its cost amount of nil, deferring the $300,000 gain until the goodwill is eventually sold inside the corporation. In exchange, the corporation issues common shares and a promissory note for boot equal to the cost amount of the assets, giving the consultant a tax-paid way to draw funds back out of the corporation as the note is repaid. The T2057 is filed by the consultant's filing deadline, the articles authorize the share class issued, and the stated capital is reconciled under subsection 85(2.1). The practice is now incorporated, the accrued value has rolled in untaxed, and the next planning step — a holdco, an estate freeze, eventually a sale — is set up on a clean basis.

Common questions about section 85 rollovers

Do I need a tax lawyer, or can my accountant handle the rollover? The T2057 election and the financial-statement work are accountant tasks. The legal documentation — articles of amendment, resolutions, transfer agreements, share certificates, register entries, and the stated-capital adjustment — is legal work. The two have to be coordinated, and the most reliable rollovers are the ones where both professionals worked through the file together at the outset.

What if a rollover I already did was done incorrectly? The file can be reviewed for the recurring faults described above, and the question becomes whether amended elections, late-filed elections, or remedial transactions can address the problem. Some defects are correctable and some are not; earlier identification generally produces better options.

Can the elected amount be changed later? Subsection 85(7.1) allows an amended election in specified circumstances, subject to the Canada Revenue Agency's discretionary acceptance and applicable penalties. The window is finite, so the elected amount should be right the first time.

Can a rollover be done after the fact? No. The transaction has to actually happen, and the election must be filed by the deadline. A rollover assembled with hindsight, after the year has closed, is a recipe for difficulty on audit.

How long do rollover documents need to be kept? Indefinitely. The adjusted cost base, paid-up capital, and stated capital created by a rollover often matter decades later — on a sale, on a future freeze, or on a death — so the documentation should be preserved for the life of the property and the shares.

How the work actually gets coordinated

The election and the financial-statement work are accountant tasks. The legal documentation — articles of amendment, board and shareholder resolutions, the transfer agreement, share certificates, register entries, the stated-capital reconciliation, and the minute-book updates — is legal work. The two have to be coordinated, because a rollover lives or dies on whether the tax election and the legal paper tell the same story. The most reliable rollovers are the ones where the lawyer and the accountant worked through the file together at the outset, planned the next step before executing the current one, and documented everything contemporaneously so the file holds up if the Canada Revenue Agency examines it a decade later.

If you are planning a section 85 rollover, incorporating a business, or trying to fix a rollover that may have been done incorrectly, Barrett Tax Law can help structure the transaction and prepare the documentation that has to line up with the tax election. The first consultation focuses on identifying the issues and the realistic options.