Holding Company Vs Family Trust

It’s not uncommon for business owners to look for ways to reduce their tax bills and liabilities. 

Most businesses begin as sole proprietorships and then start filing articles of incorporation and reorganizing their structures to give them tax benefits as they grow.

One of the hardest parts is deciding which structure you want for your business.

Two of the most common structures for asset protection and financial security are holding companies and family trusts. 

They offer different advantages. Here, we’ll explore the definitions and advantages of both, along with the main similarities and differences between them.

What is a Holding Company?

A holding company, or a parent company, is an LLC (Limited Liability Company) or corporation that controls other companies' securities and ownership interests. It doesn’t offer services or sell products on its own but rather owns stock of its subsidiaries. 

It’s treated as a separate entity, and it owns voting shares of the controlled companies. 

The holding company receives all the benefits of stockholders.

The reason business owners create holding companies is to protect their assets and receive tax benefits. It’s especially useful in real estate planning because it makes it easy to co-own assets.

Holding Company Benefits

The primary reason business owners set up a holding company is to save on tax money. 

Having a holding company in place means that you can transfer your earnings from your business through tax-free inter-corporate dividends. Doing so can put you in a lower tax bracket, and you’ll still be able to get your dividends by transferring them to the holding company and deferring your income to the next year.

The only alternative to reduce your tax money is to retain income in your company, but that puts it at risk of business creditors.

Aside from tax benefits, a holding company also offers asset protection and prevents creditor issues. If you own real estate or corporate investments, having them controlled by a holding company will protect them from creditors. As a bonus, whenever you decide to liquidate, you get substantial tax benefits.

What is a Family Trust?

A family trust is another company structure that includes the grantor, the trustee, and the beneficiaries. The trust grantor transfers the assets to be managed and controlled by the trustee, who also accounts for any losses.

The trustee is then left to distribute income from these assets to the beneficiaries of the family trust, who are often family members. 

A family trust can include spouses, siblings, children, grandchildren, or other family members as the beneficiaries. It allows for wealth to be passed on through generations.

Like a holding company, a family trust can control stocks, real estate, family businesses, and other types of investments. It can also hold the family’s assets, which provides asset protection and protects the assets from creditors.

Different Types of Trusts

In Canada, there are two main types of trusts: testamentary trusts and inter-vivos trusts. The former is created according to the grantor’s will after they pass away, while the latter is created while the grantor is still alive. 

A testamentary trust only takes effect after its grantor dies, and it’s done according to instructions left in the will and supervised by the probate court. On top of that, it must include three parties to be set up:

• Grantor: The grantor or the trustor is the owner of the trust and is the one who includes it in their will.

• Trustee: The trustee is the one responsible for managing the properties and assets of the family trust for the benefit of the beneficiaries. He may be appointed by either the grantor or the probate court in case he’s not assigned in the will.

• Beneficiaries: The beneficiaries are the family members receiving the trust’s dividends and income. 

An inter-vivos trust, on the other hand, is otherwise referred to as the living trust. It includes 31 different types dictated by the Canada Revenue Agency. Here are the more common types:

• Employee trust: In an employee trust, the employer pays dividends to a trustee for the benefit of his employees. The business income in this trust can’t be distributed.

• Alter Ego trust: In this trust, the only beneficiary is the trust owner himself. The trustor, 65 or more years old, receives all the business income during his lifetime.

Benefits of a Family Trust

A family trust has two main benefits: providing income for struggling or impulsive family members, and reducing taxes by shifting the business income to family members who are in lower tax brackets.

Impulsive family members who can’t manage their funds can greatly benefit from having someone control and distribute their income. 

On top of that, a family trust allows the grantor to transfer their assets to the trust, rendering any gains from these assets non-taxable after the grantor dies. By then, the trust will be the owner of the assets rather than the trustor. 

These assets can be shares, real estate properties, or a different form.

Other benefits of a family trust include smooth wealth transfer within the family and through generations, especially after the grantor’s death. Additionally, a family trust protects the assets because it controls them on behalf of the beneficiating family members. That means business creditors can’t take any action against any one of them.

Similarities & Differences

A holding company and a family trust are similar as they both aim at tax reduction and asset protection. Here’s a compilation of their main similarities and differences:

Tax

In Canada, there’s a lifetime capital gains exemption, often referred to as LCGE, that allows you to avoid paying taxes on a portion of your capital gains. That law is the main reason that business owners opt for family trusts and holding companies to reduce their tax bills.

If you have a holding company, you’ll regularly transfer surplus earnings to it, which decreases the amount of the taxable capital gain. As a result, you go into a lower tax bracket and pay less taxes.

If you have a family trust, you can multiply the LCGE limit by the number of beneficiaries in your trust. This multiplication helps you get a higher LCGE, which means paying even less taxes.

A family trust provides more tax benefits compared to a holding company because of income splitting.

Filing Requirements

To file for a family trust, you have to fulfill three main requirements. As the trust’s grantor, you must state your intention to start the trust, and you must identify the beneficiaries clearly. Lastly, you must clarify and itemize the assets that your family trust will control.

The process includes several steps that the trust’s grantor and the trustee settle together, including making an irrevocable donation to officially start the trust.

As for the holding company, you have to go through a set of steps to open it. Those include determining its structure and jurisdiction, choosing a name that’s not already trademarked, filing the articles of incorporation, and getting all the necessary permits and licenses to run the business. 

You’d also have to establish the board of directors and clarify the shareholder names—those typically go into the articles of incorporation that you’ll file to get your business legally recognized as a corporation.

Assets

Holding companies and family trusts are similar when it comes to managing assets. 

A holding company owns the rights to both tangible and intangible assets of its subsidiaries. An example of intangible assets is copyrights or customer lists. Meanwhile, properties and land go into the tangible assets category.

The holding company also owns a part of the company’s stock, which means it’s entitled to a portion of the profit according to the number of shares owned.

Family trusts are different in this area because they own the assets that the trustor transferred to the trust instead of stock.

Are There Any Disadvantages?

Every business structure comes with a set of disadvantages.Here are areas where family trusts and holding companies can have disadvantages:

21 Year Rule

One major disadvantage of family trusts is the 21-year rule, which applies to most trusts. The rule states that living family trusts must dispose of their properties after 21 years at a fair market value. 

In reality, the trust won’t sell the assets. 

Here’s what happens: After 21 years pass, you’ll value your assets at the current market value then and pay taxes based on the new value of those assets, even though you won’t actually sell them. The goal behind this rule is to stop families from avoiding paying taxes over many generations.

If a family doesn’t have enough cash to pay the taxes at the 21-year mark, it can be a major issue, which is why it’s considered a disadvantage.

Tax & Setup Costs

Setting up a family trust can take from two weeks up to six months, depending on how quickly you make your decisions and choose your beneficiaries. The cost of setting it up mainly depends on your lawyer, but in general, it can cost from $3000 to $10,000 to set it up. Later on, you’d only have to pay the filing fees for separate trust tax returns.

As for a holding company, you’d have to pay plenty of fees associated with setting it up. For example, you’d need to pay for filing the articles of incorporation. 

In British Columbia, it costs $350 to file them, and the cost varies from one province to the other. 

You’d also have to pay annual legal fees and tax filings, so it’s better to clear these costs with your lawyer to be on the safe side. 

When it comes to taxes, family trusts are at a higher disadvantage because they have the highest tax rate applied to all income. These trusts don’t get the benefits of tax breaks that individuals may benefit from, which means they have to pay their taxes without any deductions. 

However, there’s always the benefit of income distribution to the beneficiaries, which is deducted from the taxes that the trust has to pay.

So, Which To Choose?

A holding company gives you more control over the assets of your business, while a family trust only gives you limited control. If your priority is high decision-making power, then a holding company is your go-to.

Family trusts benefit from income splitting, which means that they pay less taxes, especially when there are multiple beneficiaries.