Benefits of a Holding Corporation
What is the benefit of a holding corporation? Laying-in a holding corporation to your operating company structure presents significant tax benefits but also limits your operating corporation’s liability. Let’s take a closer look at how this works.
Benefit 1: Tax Deferral
Layering-in a holding corporation to your operating corporation’s structure allows you to draw out and up funds from your operating company to another vehicle—the holding corporation– where it is protected from high tax rates and liability. By way of example, if an owner of an operating company requires only $50,000 to support his lifestyle, but he is earning $200,000, he is subjecting $150,000 of his personal wealth to a higher personal marginal tax rate needlessly. By drawing up $150,000 into a Canadian holding corporation and declaring it as inter-corporate dividends, those funds are now inside your holding corporation tax free, allowing you to defer your tax obligation to whenever you decide to withdraw those funds. In business, a tax deferral is always a tax benefit.
This strategy, also referred to as a ‘cash sweep’, allows you to withdraw all of the profits out of your operating company and up to the holding company tax free. It is generally advisable to draw up all your profits in excess of what the business requires for its month-over-month working capital. You should leave inside the operating corporation only the smallest amount you need to carry out your business operations; due to the inter-corporate dividend rules applicable to Canadian businesses, there is zero taxation on the money drawn up to a holding company.
What happens tax-wise when you do not do a cash sweep of funds that are in excess of what you need? The profit sitting inside your operating company is distributed through a declaration of dividends, forcing income that you may not need to you as a shareholder. As mentioned, this money is subject to high personal marginal tax rate; the top marginal rate in Canada currently stands at 54%. Paying more than half of your income to the government is a very inefficient way of holding shares in a private corporation.
Laying-in a holding corporation allows you to declare the dividend such that it doesn’t capture any additional tax on the individual shareholder. Instead, you declare the dividend to the holding corporation, which will hold the individual shareholder’s wealth. The shareholder will then be able to extract precisely what he/she needs from the holding company to support their lifestyle and no more. In this way, the shareholder controls how much income they receive by way of dividends and how much tax they will pay. One year they may take out a lot and the next year less. With a holding company, you have that flexibility. With an operating company, you don’t.
Invest your Retained Earnings and Grow your Money
Furthermore, the holding corporation, sometimes known as the family holding company, is often used to invest your profits in a portfolio of stocks, bonds and other investments. That is the vehicle that inside of which you grow your wealth as a business owner. Having drawn up the funds through inter-corporate dividends to a holding corporation allows you to grow your wealth at a much quicker rate. This is because you have 100% of the funds in which to play with, as opposed to if you had declared this personally and paid a personal tax rate of 50%. This gives you fifty-cents on every dollar of increased investment earning capacity, helping you grow your money at a much quicker rate than had you extracted personally and invested the money in a personal portfolio.
Benefit 2: Creditor Proofing
The second benefit to drawing up your excess profits into a holding corporation is limited liability, also known as creditor proofing. Every operating company that interacts directly with others—employees, customers, creditors, suppliers, and vendors—opens itself up to liability.
Every operation a company makes—hiring an employee or purchasing goods – has an inherent liability associated with it. Companies get sued all the time–by employees for wrongful termination, by suppliers and vendors for breach of contract, by customers for product liability. If a customer slips and falls inside your shop, the company will be sued. Therefore, it is precarious to keep excess earnings, your nest egg, your profit pool, inside of an operating company where the money is subject to loss as a result of lawsuits and liability.
For more information about how to draw up funds into a holding corporation inside of your operating company, contact one of our corporate-commercial lawyers today. You work hard for your money. We work hard for you to keep it.
-Shira Kalfa, BA, JD, Partner and Founder
© Kalfa Law 2021