4 Ways Canadian Business Owners Can Benefit From Using a Holding Company
DISCLAIMER
This information is intended for business owners in Canada and serves as general guidance only. Always consult with a qualified advisor before making any legal decision.
IN THIS ARTICLE, WE’LL COVER THE FOLLOWING TOPICS:
What’s a holding company?
Four reasons to use a holding company
To protect your business assets
To maintain eligibility for lifetime capital gains exemption (LCGE)
To use as an investment vehicle
To control timing of dividend payments
What’s a holding company?
Holding companies aren’t exactly companies, in the traditional sense of the word – they don’t sell a product or service, they take in zero revenue, and have no expenses or payroll. Holding companies serve just one purpose: to hold assets for tax and liability reasons.
Typically, the assets of a holding company include real estate assets, investment portfolios, and even the shares of other companies.
Should I use a holding company?
There are four reasons why a business owner may want to consider using a holding company.
To protect business assets.
Holding companies are among the most effective ways to protect your operating company’s earnings. To demonstrate this, let’s look at a hypothetical example.
Tim is the sole owner and shareholder of a small business, Tim’s T-Shirts. Last year, Tim’s T-Shirts made $1 million in profit – its best year yet. But now Tim needs to figure out what to do with all that cash.
Tim can either leave the cash in the corporate bank account, or he can pull all of it into his personal bank account. The latter option may seem attractive, as technically he’d be able to do almost anything he wanted with that money, but with one major disadvantage – about half of the money would be lost to taxes. So that option is a no-go.
From a strictly financial perspective, the better of these two options is to simply leave the cash in the corporate bank account and deal with the corporate tax rate, right?
Wrong. Because just like any other small business, Tim’s T-Shirts has relationships with its customers, its suppliers, its property managers, and other third parties.
Let’s say something goes wrong with one of those relationships and suddenly Tim finds himself in the middle of a high-stakes lawsuit. Every cent of the $1 million in Tim’s corporate bank account would be at risk. One defeat in the courtroom and he could lose it all.
Unless, of course, Tim had a holding company. If Tim entered the lawsuit with a holding company, of which he was the sole owner, that holding company would be recognized as the sole owner of Tim’s T-Shirts, thereby allowing Tim’s T-Shirts to dividend out, completely tax-free, all of the cash it doesn’t need for day-to-day operations to the holding company. For however long he wanted, Tim could let this cash sit in the protection of the holding company, pulling it out whenever he needed it.
To maintain eligibility for lifetime capital gains exemption (LCGE).
Holding companies can be useful for eliminating excess cash from operating companies. Excess cash (e.g. a passive pile of cash that isn’t actively being used in the business) can put operating companies offside of their eligibility for the lifetime capital gains exemption, one of the most important tax exemptions available to Canadian entrepreneurs.
In 2022, Every Canadian is entitled to $913,630 of a lifetime capital gains exemption (LCGE) on the sale of qualifying small business shares, an amount that scales every year. The important part is ensuring your company maintains those qualifications. There are a number of important steps to make that happen, all of which you should discuss with your accountant, but one step is to ensure there is no or little excess cash in your operating company.
The amount of cash that your operating company actively uses needs to meet a certain threshold. Specifically, 90 percent of your company’s assets need to be actively used in the business; otherwise, your shares of the company will qualify for the LCGE. This step is especially important for businesses that generate significant profits.
However, you need to be careful not to use a holding company improperly. If a holding company owns shares in an operating company, then that can imperil your LCGE eligibility. Talk with us for more details.
To use as an investment vehicle.
As mentioned earlier, there are both advantages and disadvantages to keeping all of your company’s cash in either a corporate bank account or a personal bank account. Corporate bank accounts benefit from a comparatively smaller tax rate, but are vulnerable to lawsuits; personal bank accounts come with a lot of freedom, but pulling money from a corporate bank account into a personal one comes with massive tax consequences.
Fortunately, when it comes to investing, using a holding company gives you the best of both worlds. The cash comes out of the operating company and funnels into the holding company, allowing you to make investments as you please – all while being subjected to nothing more than the corporate tax rate.
To control the timing of dividend payments.
Let’s go back to the Tim’s T-Shirts example – except now, rather than Tim being the sole shareholder, there are two additional shareholders named Bob and Julia. Each shareholder – Tim, Bob, and Julia – has one equal share of the company.
Because Tim, Bob, and Julia each have different financial needs, they’ll likely want to collect their dividends at different times. But assuming they own the same set and class of shares, each shareholder will have no choice but to receive their dividend at the same pre-set time – a situation that may not bode well for your company’s or your shareholders’ taxes.
Let’s say there’s $100,000 of dividends to be distributed to shareholders. With three equal shareholders, that’s about $33,000 each, paid to each shareholder at the same time. From the perspective of the shareholder, the timing of this dividend payout – which, again, is pre-set and non-negotiable – may have less-than-desirable tax implications.
However, if each shareholder were to set up a holding company, the timing of dividend payouts suddenly is no longer an issue. Wherever the cash sits, it will either be taxed on the corporate side of the operating company, or it will get taxed on the holding company side. Each shareholder will receive their dividend at different times.
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