This is another guest post from Thicken My Wallet, a former lawyer, who coincidentally used to setup holding corporations for his clients. I’ve asked TMW to write about holding corporations as I’ve gotten many emails regarding the details of this entity.
If you are an entrepreneur who owns a corporation, you may have heard of the term “holding corporation.” The phrase is thrown around quite a bit. Holding corporations, or Holdco for short, works for some people and not so well for others. So what is it and who may need it?
As usual… here come the disclaimers. The following is information only and should not be considered to be advice of any kind whatsoever. The laws pertaining to holdco’s vary from jurisdiction to jurisdiction so please seek qualified professional advice on this matter.
What is a Holdco?
A holdco, as the name implies, is a corporation which is incorporated for the sole purpose of holding something. Usually, that “something” is shares in an active corporation (typically referred to as an operating corporation or optco).
For example, Rose and Marie are sisters who own a winery. They incorporate a corporation, optco, to retain the employees, sell wine and own the land. The optco, in turn, is owned by the holdco. Rose and Marie own holdco. Thus, the relationship is that the individual owners own holdco who own (or hold) all the shares in optco. In other words, a corporation owns a corporation.
Ideally, holdco’s should not be “tainted” with any assets that would attract liabilities. After all, the purpose of the holdco is to act as a safe for the larger corporate structure and one tries not to weaken the safe by attracting potential liability inside it.
What is the relationship between optco and holdco then?
Think of holdco as the bank for optco. To return to the above example, every time the winery is paid, after deducting costs and salaries, it moves excess cash from optco to holdco. The movement of cash is generally in the form of an inter-company dividend (although some accountants have other means to do this so please refer to an accountant on the right treatment).
In Canada, inter-company dividends are tax-free events (given that cash has not moved outside the larger corporate structure, you still have not triggered a taxable event).
What is the relationship between holdco and its shareholders then?
If structured properly, the owners of holdco (who, remember, are indirect owners of optco) are paid through two sources. The owners are employees of the optco (i.e. they are issued a T4) and receive dividends from holdco.
In this manner, the owners contribute the CPP, have T4 income to show their banks and are taxed favorably on dividends paid by holdco to them.
The more “advanced” holdco structure involves issuing shares to immediate family members as well. The owner-managers are issued one class of voting shares and the family members are individually issued different classes of non-voting shares entitled to dividend but with no priority over the voting shares. For example, owner manager Mom is issued common shares with voting rights as owner-manager. Dad is issued Class A non-voting shares. Michael and Laura- the kids- are each issued Class B and Class C non-voting shares respectively.
At the end of each year, the directors of holdco can elect to pay dividends to any class of shares it wants with the determination as to who get what based on the tax brackets of each of the shareholders. For example, if Michael and Laura are paying only a minimal amount of tax, holdco could pay more dividends to each of them than Mom and Dad to minimize the family tax burden.
The above strategy is known as “dividend sprinkling” and is generally a safer means to pay family members on a tax-efficient manner than employing them as employees (which run into tests of reasonableness whereas a dividend can be declared as long as the corporation has the ability to meet its obligations as they become due after the payment of the dividend. Hence, the test is less subjective and not as open to audit inquiry).
Why a holdco?
Holdco’s are ideal structures when the business is cash rich but may also attract a lot of liability. To go back to the above winery example, the business may be cash-rich but think about the liability any winery incurs: bad wine, broken glass, employee lawsuits over allegedly unsafe work conditions etc etc.
Why would any self-respecting owner-manager want to leave a lot of cash in the corporate bank account if there is a lot of liability to contend with?
If you move the money up to holdco, you have sheltered it since the corporation incurring liability is optco and not holdco (please remember there are laws respecting fraudulent conveyances and preferences and in some case an optco to holdco transfer of monies may come under attack).
If you currently own an optco only, a holdco can be set up on a tax-defer basis under what is known as a section 85 rollover. Please consult your accountant and lawyer whether you are eligible for this rollover and whether it is appropriate for you.
Why not a holdco?
A person is only eligible for the lifetime $750,000 capital gains exemption if the sale of shares in an eligible small business is owned by an individual and not holdco. Therefore, if optco is sold, holdco is not subject to the capital gains exemption. One possible solution is to collapse the optco and holdco structure before the sale of optco but this is expensive to accomplish.
Holdco’s are also expensive structures to administer. Remember there are two companies to look after now. Thus, there must be a real cost-benefit before setting up a holdco structure. If the corporation is not that cash rich, an optco can be maintained and a dividend sprinkling strategy set up for optco.
Holdco’s are complicated structures to set up and maintain. They are ideal for corporations who are cash-rich but also have liabilities and the owner-managers do not mind forgoing the capital gains exemption.
As such, holdco’s are really tax-structuring Level 2. For most entrepreneurs who make a decent profit, it would be prudent to consult one’s advisor about undertaking some dividend sprinkling strategies as a means of minimizing tax.
Many thanks to Thicken My Wallet for a well written and detailed article. Be sure to visit his blog for other great articles.