What’s a holding company?

Quoth the late, great Notorious B.I.G., “I don’t know what, they want from me / It’s like the more money we come across / The more problems we see.” As an entrepreneur with a thriving business, Biggie waxed poetic on the ever-increasing difficulty of managing one’s affairs as the size and scope of one’s operation increases.

The DIY entrepreneurial spirit and flying-by-the-seat-of-your-pantsness of running a small business will only get you so far. Nobody ever really explains to you that the mo’ better you do at running your business, the mo’ difficult it gets to figure it out on your own. If you’re lucky (and good), the problems you never knew you had won’t come back to bite you… or if they do, hopefully not too hard. Obviously it’s impossible to negate all of the risk of your business, but what you can control is how much damage it will do.

One of the most important tools in your damage control toolbox comes from the shockingly unsexy world of corporate restructuring. It sounds fancy, but it’s really just another example of lawyer and accountant dweebs trying to make what we do sound impressive. Corporate restructuring means assembling a series of business entities and contracts to limit how much of your businesses’ money and assets are exposed to creditors.

Creditors are anyone your business owes money to. They can be anyone from an unpaid supplier, to a jilted landlord, to a former employee, to someone who wins a lawsuit against your business. The potential liabilities – or the amount of money you could owe creditors if things go bad – can be hefty. Say you’re opening a second location for your business. Your corporation signs a 5 year lease with a landlord for $3,000.00 per month. That’s $36,000.00 per year in rent. If the second location goes out of business after 1 year, you could still be on the hook for $144,000.00 in unpaid rent. The landlord can go after your surviving location to pay the debts from the failed one. That would suck.

A well planned and implemented corporate restructuring can protect the assets of one part of your business from the risks of another. At the heart of this lawyerly magic is something called a “holding company” – or a HoldCo.

What is a Holding Company?

A HoldCo is a corporation that doesn’t do anything other than own shares of other corporations. It’s a corporate shareholder, and nothing else. It’s called a holding company because it “holds” the shares, and it also holds on to & invests the profits that come along with those shares.

A corporation that actually does business (making/selling goods, providing services, etc) is known as an “operating company” – or an OpCo – when it’s owned by a HoldCo. A HoldCo can own all or part of one, or many OpCos, or even other HoldCos.

Profits are paid from the OpCo to the HoldCo by a dividend, which is a payout of the after-tax profits of a corporation to its owners. In Canada, dividends paid by an OpCo to a HoldCo that owns its shares are generally not taxed. This means that instead of holding a bunch of cash in your OpCo, you can hold it in the HoldCo instead, without paying more tax on it.

Why would I do that???

It may seem goofy to move the cash out of your business – after all, you may need it again. The problem is that any cash in the business is an asset that can be used to pay your creditors. Once cash is moved to the HoldCo, it no longer belongs to the OpCo. Obviously you can’t use this to hide money from creditors you already have or know about – that would be fraud, and also a dick move – but if you do it in the ordinary course of business, it’s allowed. It’s called “creditor proofing”. The OpCo only hangs on to the money it needs to run the company, and the rest is paid by dividend to your HoldCo.

Secondly, if you’ve got multiple businesses, or multiple locations of the same business, the HoldCo makes it really easy to move money between the two without paying more taxes. Since corporate tax rates are generally lower than personal tax rates, using dividends from one OpCo to fund another OpCo, rather than investing your personal after-tax income means you have more to invest.

You can also keep money in the HoldCo indefinitely, or pay yourself slowly over time to keep your personal taxes to a minimum.

Ooh, clever! How do I do it?

Every business is different, and should be set up in a way that’s designed just for it. There is no silver bullet answer. There are two approaches that I see the most often in small businesses which I’ll use as examples:

HoldCo Graphic 1

Advantages:

Simple, compared to Option 2. This means that it’s cheaper to set up and run.

It separates the assets and liabilities of each separate business, or each location or division of your business. If OpCo2 gets sued by its landlord for $144,000.00, the landlord can’t go after OpCo1 or the HoldCo for payment, because they’re separate businesses.

As we know, the excess profits of each OpCo can be paid to the HoldCo as a tax-free dividend. So, if one OpCo is doing well, and the other isn’t, the HoldCo can lend the money to the struggling company, which can be paid back later tax-free. If you didn’t have the HoldCo, you’d pay tax on the dividends you get from the OpCo, and have only what’s left to loan to the struggling OpCo.

Disadvantages:

Money. For a small business, the legal and accounting work to set it up can range from thousands to tens of thousands of dollars. It costs more to run it too – each corporation needs its own bank account, tax numbers, bookkeeping, tax return, legal work, and insurance policies, to name a few.

Also, the assets of each OpCo stay in the business, and within reach of its creditors. For businesses with lots of equipment or inventory, that could be a whole lot of value left exposed.

Typical Uses

This structure is most common in businesses where there aren’t a lot of hard assets – like services businesses – or in real estate investing, where the property is the business, and can’t be effectively separated.

HoldCo Graphic 2

Advantages

Here, OpCo1 and OpCo2 are the true operating businesses. They take on all of the business liabilities – like hiring the employees, making the products, taking customer orders, signing contracts, and so forth – but don’t actually own the valuable assets. OpCo3 owns all of the valuable assets – equipment, machinery, and sometimes inventory – and rents them to OpCo1 and OpCo2 to use.

Since OpCo3 doesn’t deal with anyone other than 1 & 2, and OpCo1 & 2 are the only ones dealing with the outside world, the valuable assets are generally out of reach of the creditors of the business. Creditors can go after the profits of 1 & 2, but they have no legal relationship with OpCo3, so have no claim against its assets.

Otherwise, it works pretty much the same way as Option 1.

Disadvantages

Again, the expense is a factor. More companies means more startup and ongoing costs.

Also, you run the risk that the money being paid from OpCo 1 & 2 to OpCo 3 for the use of the assets could be called passive income by the CRA – and taxed at a much higher rate than ordinary corporate income. This is where a good accountant earns their keep.

In some highly regulated businesses, the terms of licenses, permits, or government authorizations may prevent you from using this structure at all.

Typical Uses

This is most common where there is a lot of expensive equipment, or a great deal of inventory in the business – like resource extraction, manufacturing, transportation, or construction. A similar model can also be used by a business with multiple locations, but centralized management.

Common Failures

If you’re going to do this stuff, you’d better not half-ass it. The process of setting it all up and running it, though it may seem like overly technical, tedious legal mumbo-jumbo, is absolutely critical. This is the type of stuff that the CRA will look at in detail if you’re ever audited. Even worse than that is the possibility that you may think your assets are protected when they’re not.

There are huge benefits – tax, asset protection, and your peace of mind as a business owner foremost among them – to using these structures. If you’re going to have access to those benefits, the CRA and courts of law will require you to have done everything correctly.

A few critical factors are:

  • The paperwork must be done. Without the right legal documents and tax reporting as evidence of the intent, timing, and effect of the restructuring. You can’t pretend that you’re operating separate businesses and hope they’ll go along with it.
  • OpCos Actually Op as Separate Cos. Again, you can’t fake it. Each corporation needs its own accounts, employees, contracts… everything. If anything – employees, equipment, intellectual property, invoicing, etc – is shared between the businesses, you’ve got to have contracts in place as evidence of the separation. Any overlap between the corporations could be enough to allow a judge to ignore the structure you’ve put in place, and rule that they’re actually all just one related business.
  • HoldCo Must Not Do Business. Your HoldCo must do nothing other than own shares and be owed debt by the OpCo. If it does any active business, all of its assets – meaning all of the companies it owns – will be available to its creditors. This includes participating in the management of an OpCo through a unanimous shareholders’ agreement.
  • Solvency. If your business doesn’t have enough money to pay its expenses as they come due, then it’s illegal to restructure it unless it’s part of insolvency proceedings.
  • Current Creditors. Similarly, none of this can be used to escape creditors that you already know about – or ones you ought to know about. That’s fraud.

While it’s not rocket surgery, it’s certainly not something I recommend as a DIY project. If you’ve got a business with multiple locations, different divisions doing different things, or own pieces of a few different businesses, there’s no time like the present to square this away. If you need help along the way, I happen to know a guy…

 

Mike Hook
Intrepid Lawyer
mike@intrepidlaw.ca
@MikeHookLaw

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Incorporating an Existing Business

I’ve talked about the pros and cons of different business structures in an earlier article, but what happens when you start out as a sole proprietor or in a partnership, and later want to incorporate? The transition needs to be seamless, so that the corporation can step right in to your shoes and carry on business.

This is something I deal with regularly, and unfortunately it’s not a simple process. It’s difficult for a layman to do without some professional advice from your lawyer, and accountant or tax nerd. The details count here – to the point that writing this blog post took about 8 hours of work. Doing it the wrong way could lead to paying unexpected taxes, interest and penalties, muddy the water about who owns business assets, and stick you with personal liability for things that you thought were pushed over to the corporation. Fear not, intrepid entrepreneur – there’s a way through the maze

OK, what’s so friggin’ complicated?

There are three steps to incorporating an existing business:

  1. Incorporation and organization of a new company;
  2. Sale of the business or partnership to the corporation; and
  3. Joint election to defer the paying of capital gains tax.

Each step has its quirks, which I’ll explain below. There are a bunch of other business steps that you should take to make the transition seamless – this handy dandy checklist should help. Every case will be different – but at least you can get an idea of the key tasks. The rest of the article deals with the process on the legal side. Let’s git ‘r done:

1. Incorporation

Take the usual steps to incorporate your company –name search, and filing of the articles of incorporation with the fee payable to the Ministry. If you’ve registered your existing business’ name, and want to use a similar name for the new corporation, you’ll have to file a signed letter, or completed consent form with the articles of incorporation. You may want to include a share price adjustment clause in the articles of incorporation, in case the Canada Revenue Agency (CRA) puts a different value on the sale than you did.

The value of the shares that you’ll own will depend on the sale price. It’s important that the numbers add up, and are consistent between the sale agreement, the documents in the corporation’s minute book, and the election to defer the capital gains tax that you file.

2. Selling the Business:  Tax Rollover

Once your corporation is all set up, it is a “person” (and a taxpayer) in the eyes of the law. It can own property, enter into contracts, and do all that other fun stuff that you do for work. The problem is that the corporation doesn’t actually own anything yet, or have a right to take over your business. You own the corporation, and you also own the assets of the existing business, but they’re different people entirely. In order to merge the two, you’ve got to sell your sole proprietorship to your corporation.

The CRA will want you to pay capital gains tax on the sale. When you started your business, it was worthless. Through your hard work, it has grown in value – accumulating cash, equipment, inventory, contracts, real estate, etc. – which is a capital gain. When you sell the business, the capital gain is realized, and 50% of that amount will be added to your personal income as capital gains tax.

As pleasant as that sounds, you’re allowed to put off payment of the capital gains tax. Since you’re actually only selling the business back to yourself – you’re still are the beneficial owner of the business through your shares of the corporation – you’re not actually realizing the capital gain. You still have to pay it when you actually sell the business to someone else – but you can avoid it for now. This is known as a “tax rollover”. Lawyers, accountants, and various other nerds call this “deferring the realization of a capital gain”. Bottom line is you’ll have more money left to keep your business afloat.

To defer the capital gain, you must sell the business to the corporation at fair market value, in exchange for shares of the corporation. This is done with a “Section 85(1) Rollover Agreement”, which is a contract of sale between you and the corporation. You keep a copy, and a copy goes in the corporation’s minute book. Having a clear agreement on file is very important – the CRA likes to scrutinize these types of sales closely in order to head off tax evasion.

There are two main parts to the rollover agreement – the sale contract, and the financial terms – mostly the value of the assets, and the shares they’re being exchanged for. The sale contract should cover the following points:

  • Agreement to buy and sell
  • Shares and other compensation issued in return
  • Agreement to make a joint election to defer the capital gain under Section 85 of the Income Tax Act
  • Price adjustment clause – in case the CRA decides that the value of the assets is different than you say it is
  • Representations and warranties – that you and the corporation have the legal capacity to buy and sell the assets
  • General provisions – about how the contract is to be interpreted, and so forth

You can find examples on the interweb – Appendix A or B of this article here is a good starting point – though I don’t recommend trying to do this without legal and tax advice. The consequences of screwing it up could cripple your business if you don’t have the cash to pay the tax bill.

The financial terms – usually laid out in a table as an attachment to the contract – can get tricky. The CRA deems the assets of the business to be sold at fair market value. Some assets – especially goodwill – are hard to value. Others have depreciated or grown in value since you got them. Other assets might have a constant value, or cost nothing to acquire, but still generate income. The same goes for liabilities – though typically you don’t transfer many, if any, liabilities in these sales. You should get your accountant to value the assets, and determine the sale price of each class – or the “Elected Amount”. In the contract, you can set a price for each “class of assets” as a group, rather than breaking it down for each item. Still, your accountant should keep the working papers used to determine the amounts declared, in case the CRA asks for justification.

Typically, the following classes of assets will be sold:

  • Non-Depreciable Capital property
    • Some securities or investments
    • Some real estate
    • Trademarks
    • Some patents
  • Depreciable property – property with a definite useful life
    • Furniture, equipment, electronics, tools, spare parts
    • Vehicles and accessories
    • Buildings and the systems in them (HVAC, plumbing, electrical, etc)
    • Fixtures
  • Eligible capital property
    • Goodwill – reputation, customer lists, business name
    • Some securities or investments
    • Incorporation costs
    • Some patents
    • Non-real estate inventory

 3. Joint Election

No, I don’t mean the big issue in the next Federal campaign. It’s actually just more paperwork. Once the rollover agreement is all done and signed, the final step to deferring the capital gain is to file an “Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation.”

This riveting document is the CRA’s Form T2057. It uses much of the same information from the rollover agreement. It’s best to get your accountant to help you fill it out. The CRA will scrutinize the rollover closely. If you screw it up, you can amend the election form, but you can’t revoke an election once it’s filed.

Conclusion

That’s a lot of stuff to deal with for what seems like it should be a simple process. I strongly recommend that you don’t try this at home. It’s a tax-driven transaction – which means that your accountant should be calling the shots on the financial terms, and your lawyer should be papering the details. It’s usually a modest legal and accounting bill, which can protect you from an ugly capital gains tax bill, and the interest and penalties that come with it. Lawyer up!

Good luck out there!

 

Mike Hook
Intrepid Lawyer
http://intrepidlaw.ca
@MikeHookLaw