You’ve probably heard of a holding company, but maybe you’re not really sure how they work or what their purpose is.
Holding companies, when used properly, are excellent tools that can result in significant deferral and tax savings.
There are a lot of factors and different possible scenarios to be considered. For that reason, this article cannot cover everything and is not intended to be all-inclusive. But we will look at the most common structures involving holding companies and their uses.
First, understand that there are two types of companies we’re about to discuss: the ‘operating company’ and the ‘holding company’. The operating company is the company that runs as the business and generates the active business income. The holding company is…well, let’s find out….
A holding company can own the shares of an operating company. Whether there’s one shareholder or multiple shareholders of the operating company, holding companies can be used in this manner in both situations. Setting up a personal holding company for each shareholder in the case of multiple shareholders can provide massive tax advantages.
Ownership of the holding company
You don’t have to be the sole shareholder of your holding company. You may have a spouse and perhaps some children within your family. Making family members shareholders of the holding company can create massive flexibility with respect to income splitting (discussed below). Shares can be issued to yourself, your spouse, and/or your adult children.
To keep it simple, let’s say you’re a 50/50 co-owner of the operating company and it’s been agreed that your operating company will equally compensate both owners. Quite often, business owners are in very different personal situations. More specifically, one shareholder may have a spouse who doesn’t work and has a couple of children attending university, whereas the other shareholder may have a spouse who earns a high income and have no children at all.
By compensating the individual shareholders equally and directly as individuals without the use of holding companies, you’re more likely than not creating a significant unnecessary tax liability. This is because, depending on the situation, you’re forcing particular shareholders to be compensated more than they require to maintain their lifestyle.
With the appropriate combination of salary and dividend remuneration, you may be able to indefinitely defer significant personal income tax liability.
If you’re the sole individual shareholder in your family of a company, then your income splitting opportunities are limited. Setting a holding company up properly and having your spouse and/or adult children be shareholders is something that opens up the doors to several options. With this structure, you’re able to split the operating company’s income to multiple family members by way of salary and/or sprinkling payment of dividends. It’s not always the case, but quite often one spouse and children have significantly less income than the individual who’s intimately involved in the operations of a successful business. If that’s the case, then you’re really able to take advantage of each family member’s lower personal income tax rates. To give you an idea of what that’s worth to you in dollars, an adult in Ontario in 2014 can receive approximately $35,000 – $49,000 in tax-free dividends, so long as they have no other income!
Creditor proofing/Asset protection
If your business profits are resulting in an accumulation of excess cash, a holding company can provide your assets with a degree of protection. Often overlooked is the fact that any excess profits that remain in your operating company are immediately at risk to the claims of creditors. If you’re operating a business in a relatively risky industry, this should be a serious concern.
In most cases, your operating company can pay a dividend to your holding company on a tax-free basis. This essentially allows you to transfer excess cash to your holding company with no tax implications.
Now you’re probably wondering – what if your operating company needs that cash back to run the business? If that situation occurs, then the funds can simply be loaned back to the operating company. This loan can be secured so that it maintains priority over unsecured creditors.
Defer taxes and invest efficiently
A holding company can be a great vehicle to use if you want to invest your business’ excess profits in assets outside of and unrelated to your business; for example, investments in the stock market or real estate. If you personally draw the profits out of the operating company, then you’re paying both corporate and personal tax and investing only what’s left after you pay both these levels of tax. Proper utilization of your holding company allows you to filter out the personal level of income tax. Quite simply, you flow through the cash from your operating company to your holding company (as discussed above) and make the same investments within your holding company. This method leaves you with more dollars to invest.
Capital gains exemption
If you own shares of a corporation that satisfy certain criteria and subsequently dispose of those shares, you may be able to shelter up to $800,000 from capital gain tax. This is worth approximately $200,000 in savings. If your corporation holds excess cash and/or other assets not used to generate the businesses active income, you’ve just jeopardized your ability to claim this exemption. Proper use of a holding company can allow you to ensure you’re entitled to claim the exemption.