The Benefits of Holding Corporations: Is your Corporate Structure right for your Business? By Stefan W. Drew

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1 Corporate Structure right for your Business? By Stefan W. Drew

2 Many small businesses are started with a very simple structure. Typically, the owners of the business are the sole shareholders of a single corporation in which the active business operations are conducted, which will be referred to as the operating company. In the event a business owner is conducting business as a sole proprietor and has yet to incorporate, it is likely a good idea to incorporate. As profits begin to accumulate, however, the structure of the company quite often is not amended to reflect this growth. Effective corporate structures change with the growth of the corporation and can provide a multitude of benefits. One of the easiest and most beneficial ways of facilitating some of those benefits is by adding one or more holding companies to the structure of the business, granting the business owners increased risk minimization, wealth protection and tax minimization. Ultimately, these strategies keep more money in the pockets of the owners of the business. A holding company is a newly created corporation whose purpose is to hold some form of property, be it land, buildings, or in this case, shares of the operating corporation. Instead of an operating company being owned and controlled by its shareholders in their name personally, the implementation of one or more holding companies in a business structure allows for those same shareholders to still own and control the operating company, this time through the ownership and control of a holding company which becomes the shareholder of the operating company. This effectively maintains the same ownership control over the operating company, but with several important added benefits: Creditor Protection By adding a holding company to the existing business structure, a business owner can take excess earnings the operating company may accumulate and transfer them to the holding company as a tax-free intercorporate dividend. If the operating company ever needs access to these funds, they can be loaned back to it from the holding company. This effectively allows the owners of the business to reduce the amount of cash in the operating company as much or as little as they prefer. Since each holding company is its own separate legal entity, the earnings moved out of the operating company to the holding company are no longer part of the operating company, effectively reducing exposure to creditors in the case of hard times or litigation against the operating company. Depending on the type of business carried on by the operating company, this could be an extremely important risk minimization tool. Increased Investment Revenue As discussed above, it is generally not advisable to keep excess cash, including investments, in an operating company due to creditor protection considerations if something unforeseen occurs which would put those funds at risk. Simply put, the more assets that a given corporation has, the more that is subject to the claims of potential creditors or litigation. However, if the excess cash is paid out to the owner, by way of dividend or salary, the amount will be subject to immediate personal taxation and result in significantly less money to invest. If the entirety of the earnings are not needed for the personal use of the business owner, the operating company can transfer, again via tax-free intercompany dividends, to the holding company to invest these earnings away from the threat of potential creditors of the operating company, but still before they are paid out to the business owner and subject to personal taxation. This results in approximately 20% to 30% more money to invest, as personal tax liability is successfully deferred until the cash is needed by the business owner. Page 2 of 5

3 There are no major drawbacks to this strategy as a holding company can invest in anything that a business owner can and, in most cases, the annual investment income earned by the holding company is subject to taxation at a very similar rate as would be if the money were invested personally by the business owner. Given that most business owners do not have the benefit of a pension to fall back on and have to invest to create their retirement funds themselves, investing for retirement in this manner can be a significant boon to a savings fund. Increased Flexibility If more than one person owns the business, it is very common that the owners prefer to withdraw money from the business at different times. The implementation of holding companies to hold the shares in the operating company allows the owners of the business to move revenue out of the operating company to the holding companies, but be paid out to each shareholder incurring personal tax liability when the particular shareholder sees fit. This increased flexibility effectively allows a shareholder who does not immediately need the cash for personal spending to leave it in the holding company to be invested without incurring personal taxation on it. The money can then continue to grow until it is needed by the business owner, at which point the holding company can declare a dividend to the business owner and transfer the funds. As previously mentioned, investing the pre-tax revenue will equate to a significantly larger sum of money down the road than paying personal taxes on it and then investing it. Income Splitting The term income splitting can be generally defined as the transferring of income from a high-earning family member to a lower earning family member to shift income into a lower tax bracket and thus reduce the overall tax burden to the family as a whole in a given year. If a business owner has a family member in a lower income bracket, shares of a holding company can be given to that family member allowing dividends to be paid to them and subsequently taxed in a lower tax bracket, effectively reducing the overall tax burden to the family. By way of example, once children reach the age of eighteen they can receive approximately $15, tax-free in Manitoba which can be used as an effective way of providing for postsecondary education. Income can also be paid to minors, but will be taxed at the highest marginal tax rate, making this strategy best suited for lower income earning spouses or adult children. Page 3 of 5

4 Purification As a tax incentive for small to medium-sized Canadian businesses, the Canadian Government offers an enhanced capital gains exemption for qualified small businesses. This exemption was increased to $800, in 2014 and is indexed for inflation thereafter. This means that when selling the shares of a business, subject to passing several tests, the shareholder is exempt from paying capital gains taxes up to the exemption amount, resulting in significant tax savings. One of these tests is that, at the time of sale, 90% of the fair market value of the assets of the corporation must be used to generate active business income. The use of a holding company to remove excess assets not used in active business, i.e. cash, can help ensure the business is purified and passes this test. It should be noted that there are several other considerations necessary to be eligible for the capital gains exemption, some of which are complex and may be subject to a waiting period prior to undertaking a sale of shares. Please let us know if you would like to discuss these considerations further. Cost Considerations Professional fees are required for incorporation as well as ongoing fees for and annual legal and accounting maintenance. While these costs are generally easily offset by the benefits outlined above, consideration should still be given to the size of the business and the structure of the ownership of the business prior to determining if any alteration to your business is appropriate. Closing Each business, and the personal preference of the owners, is unique and the above considerations are just some that may benefit your business. Talk to us about whether the current corporate structure of your business is the right one. Page 4 of 5

5 DISCLAIMER This article is presented for informational purposes only. The content does not constitute legal advice or solicitation and does not create a solicitor client relationship. The views expressed are solely the authors and should not be attributed to any other party, including Thompson Dorfman Sweatman LLP (TDS), its affiliate companies or its clients. The authors make no guarantees regarding the accuracy or adequacy of the information contained herein or linked to via this article. The authors are not able to provide free legal advice. If you are seeking advice on specific matters, please contact Don Douglas, CEO & Managing Partner at dgd@tdslaw.com, or Please be aware that any unsolicited information sent to the author(s) cannot be considered to be solicitor-client privileged. While care is taken to ensure the accuracy for the purposes stated, before relying upon these articles, you should seek and be guided by legal advice based on your specific circumstances. We would be pleased to provide you with our assistance on any of the issues raised in these articles. Please click here to sign up our quarterly e-newsletter. ABOUT THE AUTHOR Stefan W. Drew Phone: swd@tdslaw.com Web: Stefan W. Drew is a lawyer at TDS Law, and was a Summer Student with TDS Law in 2013 and Page 5 of 5