Understanding Fair Market Value (FMV) and Its Impact On Your Tax Bill

Most businesses begin in the garage of the owner’s home. It is common for business owners to use their vehicle, their computer, and their place and equipment for business purposes. For instance, a graphics designer may execute her first project on her laptop. Or a baker may bake cookies in his home oven. However, as orders grow, you might want to transfer the assets to the business if you use it full-time for business orders.

Whether you buy an asset from the market for cash consideration or transfer it to your business or your children for no cash consideration, it is considered a sale by the Canada Revenue Agency (CRA). And where there is a purchase and sale, there is a fair market value (FMV). A transaction goes through various types of taxation, from capital gain tax (CGT) to goods and service tax (GST) to capital cost allowance (CCA). And the basis of all three tax calculations is FMV.

What is Fair Market Value?

Straight from the CRA’s website, “Fair market value is normally the highest price, expressed in dollars, that property would bring in an open and unrestricted market, between a willing buyer and a willing seller who are both knowledgeable, informed, and prudent, and who are acting independently of each other.”

The FMV is the price at which the ownership of an asset is transferred, even if parents are transferring a car to their child. This is because any ownership transfer is a deemed sale in the eyes of the CRA and is subject to taxation. Hence, if you are transferring your oven to the business for no cash consideration, follow the FMV structure to avail yourself of tax benefits and avoid penalties.

Application of Fair Market Value in Different Scenarios

You will see the FMV term coming in various scenarios and different transactions, from tax planning to estate planning to buying and selling of business. And in each scenario, the tax treatment is different. Let’s look at some of the most common scenarios.

Transfer of Personal Assets to Sole Proprietorship

For instance, James purchased an oven for $1,500 a year ago. He transferred the oven to his bakery shop and is using it full-time to bake cookies. How will he show this in his books of accounts?

As a sole proprietorship, he can look around for the FMV of the 2023 oven model available online or the price of a 1-year used oven. Suppose he arrives at the value of $1,250. He can use this amount to start deducting depreciation for an oven as determined by the CRA. You can find the depreciation rate in the Capital Cost Allowance (CCA), which divides the asset cost over its useful life and allows you to reduce your taxable income by the CCA amount.

Moreover, if James is registered with the GST, he can also claim an input tax credit (ITC) on the $1,250 FMV. He paid GST when he bought the oven a year ago. Since it is being used for business, he can reclaim the same GST rate but at the new FMV.

Had James continued using the oven as a personal asset, he would not have been able to deduct CCA nor claim ITC.

Transfer of Appreciating Property to Sole Proprietorship

Many times, business owners use their land to conduct business. Suppose you purchased a plot for $85,000 five years back and are now transferring the land to the business for no cash consideration. In such a scenario, you must determine the property’s FMV at the transfer time. It is suggested that a third-party valuator be consulted to determine the FMV of real estate property. Suppose the value has appreciated to $125,000. You will have to show a capital gain of $40,000 in your books even though no cash exchanged hands, and you will have to pay a capital gain tax on it.

The laws could get confusing with real estate property. Hence, it is better to seek the help of a professional tax consultant.

Transfer of Assets from Sole Proprietorship to Corporations

When you transfer the assets or property from a sole proprietorship to a corporation or partnership, you don’t use FMV. Instead, the parties involved arrive at an “elected” amount, which might differ from the FMV, provided certain conditions are met. The corporation will add the asset to its balance sheet at the elected amount and deduct CCA, and the sole proprietor will realize the proceeds for the transfer.

Transfer of Business or Asset to a Trust

Many business owners transfer the assets or shares of the business to a family trust as it allows tax-free transfer. However, a trust only defers the capital gain tax to a later date. A family trust has a 21-year life. On the 21st anniversary of the trust, the CRA will deem that all the assets in the trust are sold to beneficiaries at the FMV, and they will have to pay a capital gain tax at that time.

The trustee can also sell the assets over the 21-year tenure and pay capital gain tax when they realize it, dividing the tax burden over the years.

Transfer of Business Ownership

A business owner can also sell their business to a third party. In each case, the FMV of the business has to be determined. A professional business valuator can help you value your business. Depending on how the sale agreement is drafted, the buyer will add all the business assets to his balance sheet at FMV and deduct future CCAs from FMV. Any excess amount the buyer pays for the business will go under goodwill.

As a seller, you can claim the lifetime capital gain tax exemption (LCGE) if you qualify. Availing this benefit requires stringent planning, and a professional tax consultant can help.

Contact KSSP Partners LLP in Markham to Help You with Tax Planning

A professional tax consultant can help you maximize business transactions and bring significant tax savings. At KSSP Partners LLP, our tax consultants can provide customized tax planning for your financial situation. To learn more about how KSSP Partners LLP can provide you with the best tax expertise, contact us online or by telephone at 289-554-5997.