You are at a networking event with like-minded business owners and entrepreneurs discussing a variety of business topics. You encounter one business owner discussing that he recently set-up a holding company for his corporate structure and you are wondering why you haven’t heard of them or why you don’t currently have one in place.
A holding company is a legal company that owns shares of the operating company. The holding company does not operate its main business from it but rather is done in the operating company. In this blog, we discuss the 3 main benefits to using a holding company as part of your business structure.
1. Creditor Proofing:
Business owners work hard to maintain their wealth. Leaving assets in your business makes it vulnerable to creditors. Statistics have shown in the past that there could be a decent chance that creditors may come after you one day.
It is true that incorporation of your operating company will provide a degree of separation between your personal assets and liabilities and those of your business. However by putting your operating company under the ownership of the holding company, you’ve essentially added an extra layer of protection from creditors since they can’t make claims against the assets held by holding company.
Once you’ve established your holding company, start using it wisely by doing things such as transferring redundant assets to it. These may include the land & building, and extra cash not used in the operating activities of the business. Moving cash from the operating to holding company is achieved by way of inter-corporate dividend, and it will generally be tax-free to the holding company. What if the operating company needs cash? Have the operating company borrow the cash under a general security agreement and ensure you charge interest on that loan. By doing so enables the holding company to be a secured creditor, and will be second in line to bank lenders.
2. Using up your $750,000 Lifetime Capital Gains (LCG) Exemption Now.
There comes a time where you may eventually consider selling your company (or upon your death) and will require proper tax planning in advance in order to utilize your $750,000 LCG exemption. To be afforded the LCG exemption, certain conditions must be satisfied in respect of the shares of your operating company. This topic will be discussed in a later blog. But for now, let’s assume that your shares in your operating company are considered Qualifying Small Business Corporation Shares (QSBC shares) for the purposes of using your LCG exemption.
Instead of waiting for the actual sale of the QSBC shares to a third party (or upon your death), you can “crystalize” your capital gains exemption now. Obtaining a valuation of your operating company would be the first step in this process. Once obtained, transfer those company shares in exchange for shares of the holding company, which will be fixed-value shares equal to value of your operating company. That process is done by way of election under section 85 of the Income Tax Act. By using the election, you will trigger a capital gain to the extent of your available LCG exemption. The end result is that you will not pay any income taxes when you eventually sell the holding company shares (or upon your death), resulting in tax savings of approximately $160,000.
This type of “in-line” structure may have some pitfalls should the holding company not meet the QSBC test. As such there are better structures that may be implemented that involves both the holding company and a family trust in order to to meet the QSBC test, which will be discussed in a later blog.
3. Efficient use of after-tax corporate earnings
It is usually common that unrelated shareholders may have a stake in the operating company. And there will come a time where those parties have differing views on how to spend the after-tax corporate earnings of the operating company. The choices could be to either pay dividends or salaries, and/or make capital investments. But what if each shareholder cannot come to terms on the use?
Each shareholder should consider using holding company for the purpose of distributing the after-tax corporate earnings by way of inter-corporate dividend tax-free based on its proportionate share. Each shareholder at their discretion will be able to make a decision on how to efficiently use those earnings. Options may include reinvesting the money in other investments, repaying down shareholder loans, or paying personal dividends.
This blog posted on Dome Duong Chartered Accountant provides information of a general nature and should not be considered specific advice, as each reader’s personal financial situation is unique and fact specific. There are many pitfalls to the strategies discussed above and professional tax advice with your Kelowna accountant is essential.