Let’s answer that question with an example! About ten years ago, when Julie and Charles were a young couple in their thirties, they started an IT company together. The business grew far beyond their expectations: today they have dozens of employees, offices in three cities, booming sales and enjoy substantial positive cashflow. In fact, their company accounts for the majority of their investments, since they’ve left the greater part of their wealth in it.
For the past while, their financial security advisor and their accountant have been suggesting that they consult a tax specialist to see about restructuring their business using a holding company. What does that involve?
Two Companies Instead of One
As shown in the diagram, when an entrepreneur sets up a holding company, or “holdco,” he ends up transferring the ownership of his company, now called an operating company, or “opco,” to the new holdco. In exchange, the entrepreneur receives shares of the holdco. Ultimately, the entrepreneur usually becomes both an employee of the opco, which can pay him a salary, and a shareholder of the holdco, which can pay him dividends.
Before outlining the potential advantages of this setup, it’s important to note that tax law is a specialized area that can produce structures that are much more complex than this. As well, the tax reform announced by the federal government in early 2018 contains a number of elements that could have an impact on how entrepreneurs can use their holding companies as time goes on.
That said, here are the three main reasons why an entrepreneur might generally look into setting up a holding company:
The opco can transfer any profit not required for operations to the holdco in the form of a tax-free dividend. This distances the shareholders’ assets from any business risk associated with the operating company. Let’s imagine, for instance, that a client sues Julie and Charles’s company for a serious offence committed by an employee, and wins. This situation could put the company at risk, but if the wealth that Julie and Charles have accumulated through their long years of work isn’t in the opco, it might have better protection from creditors
On the other hand, what happens if the opco needs some cash – for expansion, perhaps – when most of the liquid assets are in the holding company? The holdco could simply give back the amount needed in the form of an inter-company loan.
Since, in our example, Julie and Charles are not only employees (of their opco), but also shareholders (of their holdco), they have a degree of flexibility when it comes to establishing the nature of their income (salary vs. dividends), as well as the amount, how it is distributed between them, and the timing.
The holding company could also be a very handy tool when it comes to estate planning.
Finally, Julie and Charles can use their holdco to purchase and manage their investments, whether for retirement or for other plans, such as investing in real estate, starting another business or helping a young entrepreneur launch a startup. Here too, however, it could be crucial for them to get good accounting and tax advice to determine which investments are best made through a holding company – and which aren’t.
One last thing that’s important to remember: setting up and maintaining a holding company involves significant expense. For this reason, it is generally recommended that the owners of smaller businesses make sure beforehand, with the help of their specialist advisors, that the benefits of this structure will outweigh the associated costs.
The following sources were used to prepare this article:
Yourmortgageoptions.ca, “Real Estate Investing Canada.”
Osler, “Federal Budget Briefing 2018,” February 27, 2018.
The Globe and Mail, “How to defer tax by using a holding company,” updated May 9, 2018.
Malek Laflamme, “Avantages d’un holding,” December 1, 2015.
Connectcpa.ca, “What Is A Holding Company And Do I Need One?”, February 18, 2017.
Les affaires, “Créer une société de portefeuille au bon moment,” October 20, 2011.