Should I have a holding company?
I am frequently asked this question. And my answer changes from client to client. Holding companies are like shirts – while one size fits many, it is not right for most. Sometimes, holding companies are a waste of money that also obfuscate, create confusion and take-up time with accountants, tax auditors and lawyers. In other circumstances, holding companies may serve to save taxes, protect accumulating profits and enable tax efficient allocation of financial resources between different operating companies according to their needs.
Many of the supposed benefits of holding companies can be obtained in other ways that are either simpler or more effective. For example, it is often said that holding companies enable the shares to be issued to spouses and adult children, with several benefits, including: (a) corporate income may then be “split” with lower income family members by paying dividends; and (b) the one-time lifetime capital gains exemption can be multiplied with a spouse and adult children. The owner-manager can achieve the same result with some thoughtful planning when first setting up. Alternatively, a subsequent re-organization could create a discretionary family trust to own the shares for the family to provide these tax opportunities (along with other family and non-tax business objectives).
Whether a holding company is likely to be a material advantage, or any benefit at all, often depends on the source of income that the holding company is likely to earn. If it will earn passive income (such as interest and dividends from a portfolio of financial investments in stocks and bonds), the holding company does not have a significant advantage because it is required to pay refundable “Part IV tax” on such income. This Part IV tax, refunded to the company when it pays dividends at the rate of $1 for every $3 of dividends, eliminates the deferral of tax which would otherwise be available to the holding company for passive income.
The Part IV tax does not apply to dividends received from “connected” corporations. An operating company with active business profits that is controlled by the holding company will be “connected” with the holding company. Dividends of the operating company’s profits to the holding company that controls it are tax-free to the holding company. This creates one of the most significant benefits of a holding company for most owner-managers, because having received the profits from the holding company free of tax, the holding company will have more capital on an after-tax basis for investment.
Even if the holding company does nothing more than invest in a portfolio of stocks and bonds, the tax deferral on the receipt of active business profits are significant and worth while, especially with the benefits of compounding over time.
Often, the owner-manager will have other uses for tax-free dividends from an operating company. If profits need to be retained in the business to finance its growth or reduce reliance on bank debt, it is a simple matter to distribute the profits out of the operating company to the holding company on a tax-free basis, and then have the holding company lend them back to the operating company as a secured loan. In effect, the profits retained in the business become secured against the claims of general creditors should the operating business become unsuccessful or suffer a large catastrophic loss.
Finally, she can use the holding company to invest by secured or unsecured loan or equity capital in a different business. In effect, the holding company does not pay tax on dividends out of active business profits, she can tax effectively use the holding company to invest profits of one operating company to fund the operations of her other operations, with some added creditor protection.
© Morrison Brown Sosnovitch LLP, 2014. All rights reserved.