If you have been reading information online regarding setting up a PREC (a corporation designated for realtors), a common topic you may have come across is that of transferring your assets owned personally (and used for business) to your corporation. Lawyers and accountants often refer to this transaction as a “section 85 rollover”, whereby you can defer the taxes on any accrued gains existing on these assets (since you’re technically “selling” these assets to your corporation at fair market value).
While you may be scratching your head thinking, “A realtor has ZERO business assets that have accrued in value – their car, their office furniture, even their computer that they use to read articles like these, lose value over time. Therefore, why do I need to pay an accountant or lawyer a ton of money to undergo this sophisticated rollover?”
The lawyer or accountant would then often say, “But you have invisible ‘goodwill’ in your business that accrues in value. Therefore, you still must undergo this rollover; otherwise, the CRA will make up a value for you, force you to pay a ton of tax, and make you suffer ‘till Thy Kingdom Come!”
Now this is the part of the conversation where I often object. The Income Tax Act does not specifically define what “goodwill” is; however, case law has added some clarity over the years. Specifically, there are two distinctions of goodwill to keep in mind: “business goodwill” and “personal goodwill”. In Canadian Winecrest Inc. v. The Queen [2011], the Tax Court of Canada noted business goodwill to consist of a business’ reputation, patronage, and other intangible assets that are considered when appraising the business, or the ability to earn income in excess of the income that would be expected from the business viewed as a mere collection of assets. In layman’s terms, this “business goodwill” represents the additional amount that a buyer would pay for your business over the fair value of its net assets since the business itself has a lasting advantage.
Personal goodwill, however, was accepted by the Court to be, “the ability, skills, experience, contacts, and reputation of individuals. It resides with the individual, it is not transferrable per se, and has little or no commercial value” (Marcon v. Canada [2009]). Furthermore, in Les placements A & N Robitaille Inc. v. M.N.R., the Court stated that the test to determine whether goodwill is personal is: “If the person withdraws from the business, will any goodwill remain?”
Here’s my take on why I believe most realtors out there have more “personal goodwill” over “business goodwill”:
- There is individuality associated with the business – i.e. realtors attach their name, and even their face, to their business’ marketing efforts. More importantly, the realtor is often the sole person executing the entire realty operation (with the assistance of close family and a few associates). Therefore, even if a realtor happens to get good referrals and leads from others, resulting in future earnings potential, this is primarily due to their own “skills, experience and reputation” (i.e. it’s tied to that individual, not their “business”).
- It’s very uncommon for realtors to sell their business to other realtors (and this is after speaking to many realtors, not my own personal opinion). Again, a lot of this has to do with the fact that their business is tied to that individual – i.e. if they sold their business to another realtor, it would be difficult for that other realtor to reap rewards (via referrals) from previous clientele who associated with a different person. It’s worth noting that is much more common to see larger brokerages, rather than individual agents, sell their business to different parties.
Even after taking all this into account, someone may still argue, “Well I may not have any real ‘business goodwill’. But to be on the safe side, shouldn’t I just go ahead and do the rollover?”
My response to this usually is, “What are you really afraid of?” As much as we have heard countless cases of the CRA being unfair to taxpayers over the years by assigning arbitrary amounts to their tax liabilities, it is very rare for the CRA to go after goodwill valuations specifically. However, even if CRA decided to start a new program to go after every PREC in Canada, it’s important to consider that any arbitrary assessment can always be challenged, even without going to tax court. Furthermore, intangible assets like goodwill are very complicated to value, especially since it requires separately identifying what portion of your commission revenue now and in the future will come from business referrals rather than direct advertising & other sources. Generally speaking, given that resources at the CRA are scarce, they will only pursue something actively if they know they have a lot of substance behind what they’re doing.
Now am I saying that it is virtually impossible for a realtor to not have any business goodwill, and that the section 85 rollover is a useless exercise for everybody? Of course not! Every realtor’s situation is different. However, I do believe that it is not right to naturally assume that you must have significant business goodwill simply because you are a realtor making a decent income.
Steven Pitucci, CPA, CA
Co-Founder, RealtyTax Professional Corporation
steven@realtytax.ca