Do you own a company or want to start a business and want to protect your assets? Then chances are, you may have heard about the difference between holding companies and operating companies, and their various advantages and disadvantages.
A holding company or “Holdco” is a company that holds the assets of an operating company (Opco). Holding companies do not produce goods or services, as they are not operating companies, but they are used as a means to preserve the assets of a business.
Advantages of a holding company
Asset/ Creditor protection
One of the major advantages of owning a holding company is its benefits of allowing the shareholder to protect the assets of the operating company. In the legal world, a corporation is treated as a separate legal entity. This means that if you own a corporation, then the court would consider you and the corporation as two separate entities. This ensures that your personal assets cannot be subjected to any lawsuit if the corporation is sued or if it the corporation goes bankrupt. The same principle would apply where one corporation is the shareholder of another, as is the case with the business structure of the holding company and the operating company. This is one key reason many entrepreneurs protect the assets created in their operating business by transferring excess cash, property or machinery to the holding company.
In order for a person to initiate litigation, they must have a ground or basis to bring a claim. It is very unlikely that actions are brought against holding companies since they do not sell a product or service, thus closing the window for lawsuits. Holding companies rarely, if ever, interact with the public. Operating companies can be subjected to litigation since they must interact with the public. This is seen when the business provides services that expose the company where an employee is negligent in their actions and causes some harm to the customer. Some operating companies can have no assets, since all the assets are placed in the holding company, thus making any lawsuits against them fruitless.
Income splitting/ Income sprinkling Income splitting is where high earning individuals allocate some of their income to low earning family members to lower their tax bill. Since Canada has a progressive tax system, it means the more you earn the more you are taxed. Investment splitting works by allowing the lower earner to own the investment and collect the income. However, the CRA has implemented the Tax On Split Income (TOSI) rules to prevent taxpayers from artificially using income splitting to reduce their taxes and thus limited the types of income business owners are able to split.
Where corporation owners hire family members to work in their company, they must ensure the family member is treated as a regular employee. This means they must be paid a fair market wage from the business, and all their CPP and EI contributions must be met. Another critical element is ensuring the family member actually does work in the company and is not simply placed on the payroll. The transactions must be recorded to prove legitimacy should the CRA perform an audit. A common pitfall many entrepreneurs face when trying to execute this method, is that they hire their spouse as an assistant, but pay them well over market value for someone performing the same role. The CRA will deem this as a way of income splitting, and deem the owner to be in contravention of the regulations and guidelines.
Tax savings and deferrals
Operating companies are subjected to the corporate tax rate. Entrepreneurs can receive payment from their companies either through a salary, which is subjected to the normal income tax rate, or through dividends made after the corporate tax is paid. The dividends are still taxed but instead of taking them personally, the shareholder may choose to reinvest them into the holding company. The tax rules allow tax-free dividends to flow between Canadian-Controlled Private Corporations (CCPC). Through this method shareholders may defer withdrawing money until when their income bracket is significantly lowered, resulting in their tax rate being lowered.
Lifetime Capital Gains Exemption
With the Government of Canada’s new capital gain increase in 2024, corporations now face a tax rate of 66.7% on capital gains, instead of the old 50%. The increase in tax rate has also seen an increase in the lifetime capital gain exemption limit to $1,250,000 in 2024. This exemption applies to Qualified Small Business Corporation Shares (QSBCS).
A share of a corporation will be considered to be a QSBCS if all the following conditions are met:
At the time of sale, it was a share of the capital stock of a small business corporation (see below) and the business was owned by the you, your spouse or common-law partner, or a partnership of which you were a member.
Throughout that part of the 24 months immediately before the share was disposed of, while the share was owned by you, a partnership of which you were a member, or a person related to you, it was a share of a Canadian-Controlled Private Corporation and more than 50% of the fair market value of the assets of the corporation were:
used mainly in an active business carried on primarily in Canada by the Canadian-controlled private corporation, or by a related corporation
certain shares or debts of connected corporations
a combination of these two types of assets
3. Throughout the 24 months immediately before the share was disposed of, no one owned the share other than you, a partnership of which you were a member or person related to you.
A Small Business Corporation (SBC) is a Canadian-Controlled Private Corporation (CCPC) in which all or most (90% or more) of the fair market value of its assets:
are used mainly in an active business carried on primarily in Canada by the corporation or by a related corporation
are shares or debts of connected corporations that were small business corporations
are a combination of these two types of assets
It must be noted that the capital gains exemption is only available to individuals and not to holding companies. Therefore, proper structuring of the shareholdings of the operating company is essential. Where the Holdco is useful is in keeping the Opco ‘purified’. This means that the excess cash from the Opco is invested within the Holdco to ensure the Opco’s assets remain above 90% and are considered actively used in the business.
If the cash is invested through the Opco, it is not used in the active business, as it sits as an investment and just accrues interest. This is considered a capital gain and can shift the requirements for a small business. Entrepreneurs need to be wary of this concept and be mindful of how they use the excess cash within a business.
Estate Planning
A holding corporation can be beneficial in the estate planning process through an “estate freeze”. This is where the current value of an asset is frozen at its fair market value. This is usually done when common shares in the operating company are exchanged for fixed value preferred shares in the holding company. This allows your heirs and successors to benefit from the future income generated by the operating company.
Disadvantages of a holding company
Added Complexity
A holding company adds another layer to a business structure. With another company involved, it requires more planning and design to ensure the holding company is fulfilling its purpose and not adding to the tax burden. Improper structure and poor management can result in additional taxes.
There is also the issue of regulatory compliance. The law concerning corporations and taxes are complex and not easily understood by the everyday person. Therefore, professional guidance might be required to ensure you are following all the regulations imposed by the government. Shareholders who fail to follow these regulations will be penalized.
Added Costs
There are a few upfront costs associated with holding companies such as the fee for the incorporation and business structuring. Every year, tax documents will need to be filed and proper booking keeping throughout the year is required to ensure no issues arise during any audits that may occur.
Do you always need a Holdco if you have an existing Opco?
Given the advantages and disadvantages of a Holdco, there are some circumstances where you might not require for your Opco.
If your business does not have many assets- A Holdco allows for the safeguarding of assets through the corporate veil of protection, but if your Opco does not hold many assets in the first place, there would be no need for an added layer of protection. For example, you have a service based Opco such as a bookkeeping business where the main assets would be computers and printers. The added complexity of establishing a Holdco to protect such few assets would be counterintuitive. The same concept applies to the cash within the business. If you constantly withdraw a salary, there would not be much cash left to be considered retained earnings in the business, so the assets of the business would be further reduced.
You want to avoid a complicated business structure- Having a Holdco adds another layer of complexity to the existing business structure and might not be suited for smaller businesses that are owned and operated by one person. If you elect to have a Holdco and an Opco, you must always be wary of the changing laws and this might not always be ideal for one business owner operating a simple business.
It might be difficult to attain financing- If you park your assets in the Holdco, your Opco might face difficulties in attaining financing as it would not be able to show any assets. As such, the Opco would look somewhat empty on the financial books. Based on the limited assets and basically little to no retained earnings, there would be no collateral for the financers to guarantee repayment.
How can Yanique Russell Law help?
Starting a company can be a daunting task, especially if you are new in the entrepreneurial sector. Our team at Yanique Russell Law can help you incorporate your company and assist with a proper business structure to ensure you can fully benefit from your holding company while staying within the law. Some of these concepts are very technical in nature and required the assistance of a qualified accountant. We can recommend you to trusted professional that are in our network to ensure you receive competent advice and further guidance on your tax planning strategies.
Conclusion
A holding company is an effective tool in the pocket of Canadian entrepreneurs that can assist them in their tax and estate planning. With the right planning and structuring it can far outweigh the initial costs, but proper legal and tax advice should be sought before engaging in this endeavour to ensure it is approached the correct way.
References:
Scotiabank - What's a holding company and is it right for your business?
Grant Thornton - Four reasons to pay attention to your company’s balance sheet
MNP - Do I need a holding company?
Government of Canada Website
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