Holding companies is not a new concept. While large companies use holding companies to preserve wealth, small business owners can also use them for several reasons. But a small business owner needs to identify why he needs a holding company and look for a cheaper alternative. Because the holding company comes with a one-time registration cost and an annual legal, accounting, and tax cost. Benefits should outdo costs to make the holding company a viable alternative. 

In this article, we will discuss four scenarios where small business owners might need a holding company and analyze if it is worth it. 

What Is a Holding Company? 

A holding company holds assets like real estate, vehicles, investments, shares of your company and any other form of passive income. Unlike an operating company that earns from selling goods and services, a holding company earns from investments (dividends, rent, and interest). Its expenses are the legal and accounting fees and taxes. 

Four Uses of a Holding Company for Small Business Owners 

The holding company structure has its uses. 

Protecting Assets From Business Risk

Business owners can withdraw money through salary and dividends. While your salary is per industry standards, the dividend amount is at your discretion. Withdrawing a high dividend amount will add to your personal income tax, which is higher than corporate tax.

And if you keep dividends in the business and reinvest them in shares and deposits to get the benefit of lower corporate tax, your money is exposed to operating risks. A business has its ups and downs. A possible lawsuit or a credit action exposes all company assets, including your dividends accumulated in the business over the years. You can protect your dividends by transferring them into a holding company tax-free. 

When the operating company faces a lawsuit or bankruptcy, the other party cannot touch the assets in the holding company, which is a separate entity. Your assets are protected from business risks, making a holding company a viable option when business risk is high. But even a holding company cannot protect your assets if the legal action is related to fraud. 

Tax Deferral 

Instead of receiving significant dividends and increasing your income tax bill, you can transfer dividends tax-free into a holding company. You can determine how much dividend you want to withdraw from the holding company. For instance, John received a windfall profit of $150,000 from a side project. In the same year, his company declared a $60,000 dividend. Instead of paying 29% income tax on the dividend income, he transfers it to a holding company and withdraws it in subsequent years. 

But John should consider the holding company option only after exhausting his contribution limit in all registered accounts (RRSP, RESP, and FHSA). Registered accounts allow you to deduct contributions from your taxable income and let your investments grow tax-free until withdrawn. Whereas in a holding company, your investment income is taxed at the corporate tax rate until withdrawn. 

There could be more instances where keeping the money in the holding company draws tax on both investment and dividend. Also, there could be instances when a particular transaction falls under anti-avoidance rules, removing the holding company tax benefit. A tax expert can help you calculate your tax liability under different options and maximize tax savings.

Selling Operating Company Tax-Efficiently 

The transferring of dividends, real estate, and other passive income out of the operating company has its biggest advantage when you sell the business. Qualifying small business owners can get a Lifetime Capital Gains Exemption (LCGE) ($913,630 in 2022). So if you sold your $200,000 business for $1,000,000 last year, you pay no tax on the $800,000 capital gain if you qualify under LCGE. 

But to qualify for LCGE, at least 90% of the company’s assets should be used directly in the company’s operations at the time of sale and 50% for the past two years or more. For instance, John accumulated cash dividends in the business over the years. It has now become $300,000, 30% of the company’s overall assets. If he gets a great bid for the company, he won’t qualify for LCGE. 

John can create a holding company and start transferring passive income, and enhance the value of his operating company in the meantime. But business is about timing. If he is lucky, he could get a better offer for sale. Had he opened a holding company three years back, he could have made the most from that offer for sale. 

Estate Planning Through Holding Company

The most common use of a holding company is to transfer your company and other estates to legal heirs tax-efficiently. You can freeze your assets so that your heir does not incur a huge tax liability on the appreciated value of the assets. Your children will inherit those assets after your death and start receiving income. 

There could be other use cases where a holding company is viable. The decision depends on small business owners’ future plans and cost-benefit analyses. Talk to a tax expert about your business plans and discuss the options and viability of creating a holding company or dissolving an existing one. 

Contact Glenn Graydon Wright LLP in Oakville for Tax-Efficient Business Structure 

At Glenn Graydon Wright LLP, our tax experts can provide services to support tax optimization and wealth management. In addition, we can provide you with recommendations on preserving wealth in structures best suited for your business. To learn more about how Glenn Graydon Wright LLP can assist you with financial planning expertise, contact us online or by telephone at 905-845-6633