Has Your Business Outgrown Its Corporate Structure?

Has Your Business Outgrown Its Corporate Structure?

A shareholder owns the company by holding its shares, and voting shareholders appoint the director. A director is responsible for the company’s overall governance and oversight. In many small private companies, the same person or people may be both shareholders and directors. For simplicity, this article refers to that person or group as the “owner.”

A simple structure may work at the beginning. But as the business grows, the owner’s goals often become more complicated. The owner may want to introduce a holding company, protect excess cash from operating risk, prepare for a future sale, carry out an estate freeze, bring in family members, or reorganize the company for succession planning.

A reorganization means changing the legal or share structure of a company. The business itself may stay the same, but the ownership structure, share classes, or relationship between companies may change.

A reorganization often does not involve a true sale to an outside buyer. The owner may not receive any cash. Instead, they may be exchanging shares, transferring shares to a holding company, converting one class of shares into another, or restructuring the company’s share capital. Without rollover treatment, those steps could potentially trigger tax even though the owner has not actually received money to pay that tax. Rollover treatment means the tax rules may allow a transfer, exchange, or conversion to happen without immediate tax. The tax is usually deferred, not eliminated.

An estate freeze is one example. It is a planning technique that fixes the current value of an owner’s interest in the company and allows future growth to accrue to someone else, such as children, a family trust, or a holding company.

To understand this, it helps to understand common shares. Common shares are usually the growth shares of a company. If the company becomes more valuable, the value of the common shares usually increases with it. Future growth means the increase in value of the company after the reorganization. For example, if a company is worth $1 million today and later grows to $3 million, the additional $2 million is future growth.

A family trust is a legal relationship where trustees hold property for beneficiaries, often family members. In corporate planning, a family trust may hold shares so that future growth can benefit selected beneficiaries.

The core practical benefit of sections 51, 85, 85.1 and 86 is that they can allow certain transactions to occur on a tax-deferred basis. In plain terms, these provisions may allow a business owner to reorganize the legal structure around the company while deferring tax until a more appropriate time, such as an actual sale, redemption, or other realization event.

This matters because money that might otherwise be paid immediately in tax may remain available to grow the company, invest through a holding company, or build the owner’s wealth.

This article focuses on the potential benefits of these provisions from a corporate lawyer’s perspective.

Section 85 Rollover

Eligible Property to a Corporation for Shares/$$

A section 85 rollover is one of the most common tools used in private company reorganizations.

Commonly, this provision is used to transfer shares of an operating company to a holding company. It may also be used to transfer personally owned property or equipment to a corporation, such as where a sole proprietor incorporates an existing business. In general terms, section 85 may allow a taxpayer to transfer eligible property to a taxable Canadian corporation on a tax-deferred basis.

For example, an owner who personally owns all the shares of an operating company may transfer those shares to a newly incorporated holding company. If properly structured, the transfer may occur without triggering immediate capital gains tax. The section 85 rollover generally requires a joint election filed by both the transferor and the corporation, usually prepared by the accountant, to select the tax value at which the property is transferred.

One practical benefit is that the owner can move from direct personal ownership to a holding company structure.

Holding companies can be useful for several reasons:

Holding Company Planning

A holding company can give the owner more flexibility. It may be used to hold shares of the operating company, receive dividends, accumulate excess cash, make investments, or participate in a future sale.

For an owner, this can be a major step in maturing the corporate structure. The business may have started as a simple operating company, but over time the owner may want to separate the operating business from accumulated wealth.

A section 85 rollover can help create that structure.

Creditor Protection

Operating companies carry business risk. They may have employees, contracts, leases, suppliers, customers, lenders, lawsuits, warranties, and other liabilities.

If the operating company accumulates significant excess cash or investments, those assets may be exposed to the risks of the operating business.

A holding company structure may allow after-tax surplus to be moved out of the operating company, where appropriate, and held separately. This does not eliminate all risk, and it must be done carefully, especially where creditors already exist.

From a planning perspective, it can help separate operating risk from accumulated wealth. It may also be used alongside a family trust as part of broader estate or succession planning.

Sale Planning

A holding company structure can also assist with future sale planning.

A buyer may want to purchase shares of the operating company, not a corporation that also owns excess cash, investments, vehicles, real estate, or unrelated assets. If the structure is cleaned up well in advance, the company may be easier to present to a buyer.

A section 85 rollover can help the owner organize the ownership structure before a sale process begins. That can reduce last-minute complexity and may make due diligence cleaner.

Estate Planning

Holding companies can also be useful for estate planning, often used in conjunction with a family trust or other trust structure.

If the owner owns the operating company directly, all planning is tied to those personally held shares. By introducing a holding company, the owner may create more options for future freezes, voting control, dividend planning, and succession.

For business owners, the legal paperwork matters. Your accountant may recommend the tax plan, but your lawyer makes sure the company is set up properly to carry it out. That includes preparing the incorporation documents, share terms, transfer documents, resolutions, share registers, and minute book updates needed to match the intended plan.

Section 86 Rollover

Shares for Shares of the Same Corporation

A section 86 reorganization is often used where a shareholder exchanges shares of one class for shares of another class of the same corporation.

In practical terms, section 86 is commonly used in estate freezes.

For example, an owner may own all the common shares of a corporation. Those common shares represent both the current value of the company and all future growth.

If the company has become valuable, the owner may want to “freeze” the current value in fixed-value preferred shares and allow future growth to accrue to new common shares.

Preferred shares are often used to fix or “freeze” a specific value in the hands of a shareholder. They can be designed to have specific rights, such as redemption rights, dividend rights, voting rights, and priority over common shares.

Those new common shares may be issued to a family trust, adult children, a holding company, or another planning vehicle, depending on the accountant’s tax advice and the client’s broader estate plan.

Section 86 rollvers require:

• an alteration to the share capital of the company;
• all shares of a particular class must be transferred in the exchange; and
• no election needs to be filed at the time of the exchange with the CRA, however the dispoistion must be disclosed with the annual corporate tax filings.

The benefit is that the owner can reorganize the share structure of the existing company without necessarily triggering immediate tax.

Freezing the Current Value of the Company

The main benefit of an estate freeze is that it can cap the owner’s current value.

The owner exchanges their growth shares for fixed-value preferred shares. Those preferred shares typically represent the current value of the company. Future growth then accrues to the new common shares.

For an owner, this can be very useful where the business has significant growth potential. Instead of all future growth continuing to accrue personally to the founder, some or all of that future growth can be directed to the next generation or another planning structure.

Succession Planning

Section 86 can be useful where the owner is beginning to think about succession.

The owner may not be ready to give up control. They may still want to remain the director, control voting shares, receive dividends, and decide when shares are redeemed. But they may want future growth to benefit children, family members, or a trust.

A properly implemented freeze can separate economic growth from control. That is often the practical objective.

The founder can retain control while beginning the transition of future value.

Probate and Estate Planning

A section 86 freeze can also help with estate planning.

If the owner continues to hold all the common shares until death, the value of those shares may continue to grow. That can increase the deemed disposition tax exposure on death. It can also increase the value of the estate for probate and estate administration purposes.

By freezing the current value, the owner may be able to make the future estate more predictable. The estate may still hold valuable preferred shares, but the growth after the freeze can accrue elsewhere.

This can make planning easier for the owner, the family, the accountant, and the estate lawyer.

Control and Share Rights

For business owners, section 86 planning is not just about tax. It is also about making sure the company’s shares have the right rights attached to them.

In an estate freeze, the owner will often exchange common shares for preferred shares. Those preferred shares need to be drafted carefully. They may deal with voting control, dividends, redemption rights, transfer restrictions, and what happens if the company is sold or wound up.

If the share structure is poorly drafted, the tax and estate plan may not work as intended. The practical benefit of section 86 is that the existing company can often be reorganized internally, without selling the business or bringing in an outside buyer.

Section 85.1 Rollover  

Shares for Shares from a different corporation

A section 85.1 share-for-share exchange may apply where shares of one corporation are exchanged for shares of another corporation.

In the private company context, section 85.1 may be useful where the owner is exchanging shares as part of a reorganization or acquisition. It can also be relevant where a new corporation is being inserted into an ownership structure.

The potential benefit is that the owner may be able to exchange shares without triggering immediate tax.

Simpler Share Exchange Planning

One practical advantage of section 85.1 is that it may be simpler than a section 85 rollover in the right circumstances. Section 85 usually involves a joint election and more detailed documentation around elected amounts. Section 85.1 may apply automatically where its requirements are met.

That can reduce administrative burden.

However, the simplicity should not be overstated. Section 85.1 has conditions, and it should not be assumed to apply merely because shares are being exchanged for shares. The accountant should confirm whether section 85.1 is available and whether it is preferable to section 85.

Usefulness in Sale or Reorganization Transactions

Section 85.1 may be useful where an owner receives shares of another corporation instead of cash.

For example, in some sale transactions, a vendor may receive shares of a purchaser corporation as part of the consideration. If the requirements are met, section 85.1 may help defer tax on the exchange.

For an owner, this can be important where the transaction is not a simple cash sale. If the owner receives shares instead of cash, they may not have liquidity to pay immediate tax. A tax-deferred share exchange can help avoid that mismatch.

Holding Company and Acquisition Structures

Section 85.1 may also be relevant when inserting a holding company or participating in a corporate acquisition structure.

The practical benefit is flexibility. The owner may be able to change the ownership chain while continuing to hold an economic interest in the business through replacement shares.

From a practical perspective, the paperwork has to match the tax plan. The lawyer helps document what shares are being exchanged, what new shares are being issued, what approvals are needed, and how the company records should be updated. If the documents and sequence are wrong, the intended tax result may be put at risk.

Section 51 Rollover

Turning Convertible Shares (or Debt) into Shares from the Same Company

A section 51 rollover may apply where a person already holds shares or debt that can be turned into shares of the same corporation.

In simple terms, section 51 may apply where a shareholder or lender already holds something, such as shares or debt, that has a built-in right to be turned into shares of the same corporation. That built-in right is called a conversion right. Shares with this right are called convertible shares.

For example, an owner may hold one class of shares that can be converted into another class of shares. Or a corporation may have issued debt that can later be converted into shares.

If section 51 applies, the conversion may occur on a tax-deferred basis. No tax filing is required at the time of the exchange.

Built-In Flexibility

The practical benefit of section 51 is that it may allow an existing conversion right to be used on a tax-deferred basis.

The flexibility must usually be built into the company’s structure in advance. For example, the articles, share terms, or debt instrument may provide that one class of shares, or certain debt, can later be converted into shares of the same corporation.

If the articles, share terms, or debt instrument include proper conversion rights, the owner may later be able to convert one type of security into another without a full corporate reorganization.

This can be useful where the owner wants the ability to change the nature of their ownership interest later.

Cleaner Implementation

Section 51 can be attractive because it may allow a conversion to occur according to rights that already exist.

That can be simpler than amending the articles, creating new share classes, or completing a more involved reorganization.

For business owners, section 51 planning depends on what is already written into the company’s documents. If the shares or debt do not include a right to be converted into shares, section 51 may not be available.

The practical takeaway is simple: even a small private company can benefit from thoughtful share terms and corporate records. A simple structure may work today, but it may limit future planning options if the company later needs to reorganize.

This is one reason Johnston Franklin Bishop drafts articles for new incorporations and continued-in corporations with flexibility in mind. Properly drafted share classes and rights can give business owners more options for future tax planning, estate planning, reorganizations, and succession planning.

Practical Takeaways for Business Owners

Practical Benefits for the Owner

An owner may not have other shareholders to negotiate with, but that does not mean the planning is simple.

The owner may have several planning objectives:

• They may want creditor protection.
• They may want to preserve control.
• They may want to prepare for a sale.
• They may want to introduce a spouse, children, or family trust.
• They may want to reduce probate exposure.
• They may want to manage the tax consequences of death.
• They may want to move excess cash out of the operating company.
• They may want to make the business easier to transition or sell.

Sections 51, 85, 85.1 and 86 can help create the legal flexibility needed to address those goals.

The value of these provisions is not that they make tax disappear. The value is that they may allow the owner to reorganize at the right time, for the right reason, without triggering immediate tax unnecessarily.

The Lawyer’s Role in Tax-Driven Reorganizations

In most private company reorganizations, the accountant gives the tax advice. The lawyer prepares the legal structure needed to carry out that advice.

This matters because a rollover is not just paperwork. The company’s articles, share rights, resolutions, transfer documents, promissory notes, share registers, share certificates, and minute book all need to match the tax plan.

The owner should consider and discuss the practical issues with their lawyer:

• Who controls the company?
• Who can receive dividends?
• Who can redeem shares?
• What happens if the owner dies?
• What happens if the owner becomes incapable?
• Are there family law or creditor concerns?
• Is a shareholders’ agreement needed?
• Will the structure still work if the business is sold?

A reorganization can create significant benefits, but only if the legal documents are prepared correctly and the company records are updated properly.

Other Planning Tools May Also Be Relevant

Sections 51, 85, 85.1 and 86 are not the only tools used in private company planning.

A stock dividend may sometimes be used as part of a corporate reorganization or estate freeze. A stock dividend means the corporation pays a dividend by issuing shares instead of cash. This can sometimes help create or shift share attributes within the company, but it must be used carefully because the tax treatment depends on the share terms, value, purpose, and surrounding transactions.

A partnership rollover may also be relevant in some structures. This is usually discussed under subsection 97(2) of the Income Tax Act. In general terms, it may allow eligible property to be transferred to a Canadian partnership on a tax-deferred basis where the required election is made. This can be useful where a partnership or limited partnership is part of the business, investment, or real estate structure.

These alternatives are more specialized. The main point for business owners is that there may be more than one way to reorganize a private company. Your accountant should identify the tax option, and your lawyer should make sure the legal structure and documents properly implement it.

Rollovers Are Planning Tools, Not Shortcuts

Sections 51, 85, 85.1 and 86 are powerful because they allow private company owners to adjust their structure as the business evolves.

They can help an owner move from a basic operating company to a more sophisticated structure involving a holding company, preferred shares, family trust, estate freeze, share exchange, or conversion feature.

But they are not shortcuts.

The accountant must confirm the tax treatment. The lawyer must implement the legal steps correctly. The owner must understand the business purpose and practical consequences.

When used properly, these provisions can help the owner plan ahead instead of reacting later.

Need Help With a Section 51, 85, 85.1 or 86 Reorganization?

If you own a private corporation and are considering a section 51, 85, 85.1 or 86 reorganization, speak with your accountant and corporate lawyer before taking steps.

These transactions can provide significant planning benefits, but the tax advice, share structure, resolutions, elections, and corporate records all need to work together.

Contact our office if you would like legal assistance with a section 51, 85, 85.1 or 86 reorganization, including the corporate documents, share terms, resolutions, registers, and minute book updates needed to implement your accountant’s tax plan.

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