Sunday, August 6, 2006

Don't Get Yourself in a Headlock: Use a Holding Corporation

Andre has decided to take a sabbatical from his tax law practice to pursue his lifelong dream of opening a mud wrestling school. Wrestleco is the corporation that will operate the wrestling school, but Andre would also benefit from incorporating a holding company (“Holdco”) as well.

Holdco is not an active business company. Rather, it is a company that can be used to hold investments in other corporations or to hold non-business assets. In this case, Holdco would hold the shares in Wrestleco.

There are advantages to using a Holdco. One advantage is a degree of creditor protection. A hurt wrestler who was drop kicked and body slammed in the ring may decide to sue Wrestleco. Wrestleco could pay dividends up Holdco, thus decreasing the assets and value in Wrestleco that would be available to creditors. If Wrestleco needed any funds, Holdco could then lend the funds back to Wrestleco on a secured basis. The result is the shielding of assets that would otherwise be held by Wrestleco and available to Wrestleco’s secured creditors.

The best way to take advantage of the creditor protection would to be have a trust, not Andre, hold the shares of Holdco. The beneficiaries of the trust could be Andre’s family members. This allows Andre to be an active manager or wrestler of Wrestleco. Otherwise, the Holdco shares would be at risk if Andre was personally sued and if he personally owned the Holdco shares.

Another advantage of using a Holdco arises in the context of investing. Wrestleco, as a small business corporation, is taxed at a low rate of 18% on its first $300,000 of income (to be increased federally to $400,000 next year) in a taxation year. If Andre took money out of Wrestleco as a dividend and invested it himself, he would pay tax on the dividend (the top tax rate is 32%) and tax on any investment income. However, if Holdco owns shares of Wrestleco, Wrestleco can give a tax-free intercorporate dividend to Holdco using 18% tax-paid dollars. In other words, after pay the 18% tax, Wrestleco would be left with 82 cents on each dollar. Wrestleco could transfer these 82-cent dollars to Holdco without incurring further tax and Holdco could invest 82 cents for each dollar of Wrestleco profit. Holdco would have more money to invest than Andre would if he took the money directly out of Wrestleco. When Andre eventually takes the money out of Holdco, he would have to pay tax, but in the meantime, Holdco would have more money to work with.

If Andre decided to sell his business, the use of Holdco can provide another advantage. A qualified small business corporation (“QSBC”) share is a share in a Canadian company (“Opco”) that meets the following two tests.

  1. 90% or more (measured by fair market value) of Opco’s assets are used in an active business.
  2. Throughout the two year period prior to the sale of the QSBC, 50% or more (measured by fair market value) of Opco’s assets were used in active business.
 If the shareholder has held the shares for at least two years, he may use his capital gains exemption (up to $500,000 lifetime limit, to the extent none has already been used) in respect of gains resulting from the sale of the QSBC shares. Opco can pay a tax-free intercorporate dividend to Holdco and transfer excess assets or cash not used in the active business. This allows the shares of Opco to qualify as QSBC shares and the gains from sale of the shares be eligible for the capital gains exemption. Wrestleco could use a Holdco to help keep itself “pure” and have its shares qualify for the QSBC share status.

With a little extra planning at the beginning, Andre can put the headlock on the tax-man instead of on his business.

-- Devinder Sidhu

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.