What Is A Holding Company And Do I Need One?
So, you started a business, and your operating company (“Opco”) is running quite nicely. You’re out for coffee with a business pal, who starts telling you about his/her holding company (“Holdco”).
Their accountant said they needed one, but, they can’t quite explain the benefits.
Holding companies are used for a variety of reasons - we’ll go through some of the benefits below.
Before we begin, a Holding company is an incorporated company, just like any other operating company that has been incorporated. The main difference is that a Holdco doesn’t encompass active business activities (i.e. revenue for sales, expenses, payroll, etc.). It’s a company used mostly for tax-purposes.
Why do you need a Holding company? Here are some reasons:
Whether you’re in a high-risk industry, or are just looking for some additional protection, inserting a Holdco into your business structure can help to add an extra layer of protection over your business. If you transfer non-essential or redundant assets out of your Opco to your Holdco (i.e. cash), if something were ever to happen to your business (Opco), these assets would be protected from creditors, since they are now sitting in the Holdco.
Qualified Small Business Shares
It’s every small business owner’s dream to one day utilize their lifetime capital gains exemption in the sale of their empire that they’ve grown. In order to utilize their gains exemption, the shares of the business they are selling must “qualify”. Among many of the criteria that the business must meet, one of them is that in simple terms, they can’t have too much cash in the corporation. Holding companies allow you to transfer excess cash out of Opco in the form of an inter-company dividend (usually tax-free), to ensure that your shares of Opco remain qualified.
As noted above, in general, dividends can move from Opco to Holdco on a tax-deferred basis. When we move cash out to a holding company, we can then use this money to create an investment portfolio, whether it be through real estate, stocks, or investments in other businesses. As this money, has only paid corporate tax, not only are you working at creating your retirement fund, you are also doing so with more money than you would had you removed that money personally (in the future we will write a blog on the value of a deferral).
Timing of Dividend Payments
Let’s say your Opco is owned by multiple shareholders. When a dividend is declared, each shareholder receives their proportionate share. Without a holding company in the mix, each shareholder has to declare that dividend payment as income personally, whether they need the money or not.
This can result in animosity between shareholders when it comes time to declare dividends (i.e. Shareholder 1 may need the money and will push for a dividend payment whereas Shareholder 2 or 3 may not need the money and will push to defer the dividend payment).
A Holdco structure can save the day here. In a typical scenario, each individual would be a shareholder in their own Holdco. Each Holdco would then be a shareholder in the Opco. When the Opco declares a dividend, it first flows to the Holdco. As mentioned earlier in this post, most dividend payments from Opco to Holdco are tax-free. This mechanism allows you to move money to your Holdco (without any tax implications) and then have you (the individual) decide what to do with it.
For example, Individual 1, may then decide to move the money from his/her Holdco to them personally (at which point they pay tax personally on it). But Individual 2 and 3 may choose to keep the money in the Holdco (at which point, no tax is paid). They can then keep the money in the holding company and use it for investment purposes or they can withdraw it to themselves personally at a future date.
The benefit here is that everyone is in control of the timing of dividend payments to themselves and there are no issues when dividends are declared and paid from the Opco to each individual Holdco.
Holding companies may not be right for everyone but there are definite advantages to them. Although a single company may have worked for you in the past, your business has grown and evolved, and maybe your structure should too. Always ensure that you are talking to your accountant to determine what business structure is right for your needs.