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

Advertisements

Lawyer Stuff 101 – What Does a Business Lawyer Do?

This is the second in my series of articles on how you, a business owner, can use your lawyer most effectively. The most frequent conversation I have when meeting with new clients is to explain the role of the lawyer in advising a business. Many have never worked with a lawyer before, or worked with one in a different area. Why are we useful, and what the hell do we actually do that adds value to your business? Once you know what we do, it’s much easier to use us effectively – saving you time, money, and heartache as your company evolves.

A lawyer’s job is to help businesses to understand and manage risk. Full stop.

On Risk

Most entrepreneurs are going into business because they have a great idea – a product or service that they believe they can sell. The act of going into business is risky in and of itself. You’re putting your time, money, reputation, and relationships on the line. The business world is a scary place, especially when you’re the small fish in the pond. Your competitors are constantly working to out-manoeuvre you. Your employees, contractors, investors, customers and suppliers have expectations and problems of their own. The tax man knocks on your loudly and frequently. There’s a maze of regulations to navigate.

Many of those risks are sight unseen for entrepreneurs. Some manage to bob and weave through them by chance, blissfully unaware of close calls. Often in a first meeting I have the unpleasant task of lifting the veil, and giving them a peek at the troubled waters they’re sailing in. Sometimes the business owner walks away with more worries on their mind than they came with. It’s not a fun realization for them, and it’s my least favourite part of the job. It is, however, reality.

The risks exist whether you realize they do or not. Would you rather not know, and be blindsided when something happens, or understand where the risks lie, what the potential consequences are, and be able to make plans to avoid them and minimize their effect on your business?

Keep your head in the sand if you like, but Stats Canada has found that 20% of startup businesses fail within the first year, and 50% don’t survive three years. The businesses that succeed tend to have sound legal and accounting advice from an early stage. If you have sound advice, and the business still fails, you’ll likely end up on more stable ground afterwards – with your personal assets, reputation, and relationships relatively intact.

Lawyers help businesses to manage risk in three main ways:

  • Advising on sound business practices
  • Advising on appropriate legal structures and relationships, and
  • Advising when insurance is wise

Each of these risk management techniques ties in with the others. I’ll talk about each in turn.

Sound Business Practices

The most common, cheapest, and often most effective is to cover your own ass by doing business the right way. Most of these don’t need a lawyer to dream up or implement.

The most common business disputes are about differences between what was promised and what was delivered, billing and payment disputes, employer-employee relationships, and on-premises injuries. Businesses frequently deal with Consumer Protection Act, employee safety, and harassment and Human Rights Code complaints. Complying with government regulation – such as licensing, zoning, Building Code, Fire Code, access for disabled persons, anti-spam, import/export rules, and tax are also sources of friction and risk. It can be a lot to deal with, but there are a few habits that’ll make life easier for you:

  • Do your reading. There is a ton of information out there from government websites, regulatory bodies, accountant and lawyer’s blogs, insurance companies, incubators, entrepreneur groups, and industry publications. Read it all. A responsible business owner knows what laws and regulations govern their industry, and what they need to do to colour between the lines.
  • Put it in writing. If there’s a dispute, what actually happened doesn’t matter – only what can be proved. Written records are more convincing than memory. If you do business over the phone or face to face, keep notes and send a follow up email summarizing what was said and agreed upon. Put employee job descriptions in writing.
  • Keep everything. Having things in writing is useless if you delete it too soon. The limitation period (meaning, the amount of time someone has to bring a lawsuit) in Ontario is two years after the problem is discovered. Do the math, and figure out how long to keep the records after dealing with someone. An IT nerd can burn years and years of data to DVD for you if storage space is an issue.
  • Don’t over-promise. Sometimes the pressure to make a sale can be immense, especially in the cash-poor early days of a business. It’s hard enough to keep people happy even when you do what you say. If you over-promise and under-deliver, or take on work you’re not equipped to do, it’ll come back to bite you in the end. The rear end…
  • Have policies in place. Especially if you have people working for you. There are tons of free resources from the Ministry of Labour, and HR professionals that can get you started. It’s wise to bounce these off your lawyer to make sure they’re current.

As your company grows, your lawyer and other advisors can help to flesh out the practices and policies in a way that suits your business.

Legal Structures

Here’s where I come in. While business practices are a good start, there’s no substitute for on-point legal advice to help minimize business risk. Legal advice costs money, and if you’re in the habit of seeking it before acting, you may wonder what the actual value added to your business is. Legal advice is a bit like bear repellent – the only way you know it’s working is that there are fewer bears around… but if a bear shows up on your doorstep with a lawsuit, the value becomes much more clear. Maybe I went too far with this analogy… I digress…

Sadly, much of what I do is work to clean up my clients’ self-inflicted messes. They try to save money on legal fees by trying to be their own lawyer. Sometimes the damage is irreparable. I’ve watched businesses go down in flames because of vague, improperly drafted contracts. I’ve seen clients held hostage by independent contractors because they didn’t put anything in writing before work started. I’ve seen people’s businesses stolen out from under them because they didn’t think independent legal advice was worthwhile. Even when the business is salvageable, they often end up spending two or three times as much to fix the problem than they would have on legal advice in the first place.

The business lawyer’s role usually falls in one of three categories:

  • Internal relationships. Clearly setting out the roles, responsibilities, and expectations between the founders of the business is essential. Sooner is better – ideally before the business starts to make (or lose) money. No matter what the form of business is, and no matter how good the intentions are at the start, as soon as money is involved, people’s recollection of the deal and expectations can change in a hurry. A house divided against itself cannot stand.
  • The back end of the business. Not only should your business structure make sense from a tax perspective, it should protect the founders, and facilitate long-term growth as much as possible. There are several forms of business available, each with their benefits and obligations. Choosing the right one, and keeping it in good standing with the government and other regulators is critical. Lawyers know what records need to be kept, and what approvals must be secured before taking certain actions. Investors and potential buyers will want to see that the proper decision-making processes were followed in running the company.
  • External relationships. Customers, suppliers, employees, investors, creditors, partners, joint-venturers, government, regulators, landlords, tenants, neighbours, industry associations, and advisors will all be looking out primarily for their own interests, as you should be for yours. Contracts are useful to set out what’s expected of each party, which I covered in detail in an earlier blog. Call your lawyer before trying to enter, break, or change a contract. You may also need help understanding what regulations apply to your business, and help you to colour between those lines.

Insurance

I’m no expert in insurance – my knowledge is limited to knowing when to recommend when it might be appropriate, and how it fits into your overall risk-management plan. I typically recommend insurance options to cover the gaps between your business practices and legal structures, and the risks you can’t hedge against that way.  A few of the common types are:

  • Commercial general liability. This coverage can cover slip & fall and other bodily injury, defamation, emotional pain and suffering, false advertising, medical expenses, and tenant/occupant liability.
  • Disability & key person. As discussed in my articles on contingency planning, these policies can help keep the business afloat if the owner/operator or a key employee is killed or injured and unable to work.
  • Directors & officers. A company can agree to protect its directors and officers in the event that they’re sued for things they did in the course of their duties.
  • Business interruption. Protecting against loss of income in the event of fire, flood, equipment breakdown, and other events beyond the business owner’s control.

Written opinions of lawyers, accountants, and other professionals which recommend a specific course of action as being legal or viable can also be a form of insurance. Your business should be able to rely on those opinions to make its decisions. If an opinion is wrong, and the business suffers losses as a consequence, it’s up to the professional (or their insurer) to make it right.

Bear in mind that insurance is a contract as well – so read it. Know what you want to be covered for, and make sure it’s included in the policy. Have an idea of what amounts of coverage you need for each type of insurance. Ensure it covers liability occurring in the places where your products or services will be delivered. Do some research into the reputation and claim denial rate of the insurance company you’re thinking of dealing with. Call your insurance agent when starting a new aspect of your business. Insurance is supposed to provide peace of mind – which ain’t much use if you don’t actually know what you’re covered for.

You probably already know that there’s a lot more to entrepreneurship than meets the eye, if you’re doing it well. Getting legal advice can be a delicate balancing act as far as cost vs. benefit – especially when cash is tight in the early stages. Sometimes you need more work than you think, other times you need less. Each business’ needs will be different, and the only way to know for sure is to ask questions. Know what you don’t know, and get an expert when you need one. I happen to know a guy…. 😉

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

Legal Aspects of Business Continuation Planning

This article is the second in my series on what’s involved in planning for the worst. In the last one I gave an overview on who and what is involved in the process. This time I’ll lay out some of the legal work that may need to be done in order to put your plan into effect. The goal here is for your business to continue relatively smoothly if you die or are incapacitated. The most obvious benefit is that you or your beneficiaries will have a chance to receive the value of the business – which could be lost if you’re not there to run the business.

There are a bunch of great resources out there, largely from insurance companies and banks, about business continuation planning. Though it may seem like a lot to wrap your head around, the legal side is fairly simple. The first step is to identify what the essential parts of your business are. What’s the bare minimum that must be done in order to keep the doors open? Who’s capable of doing those things? What’s to become of your control of the business, and your share of the profits? Once you’ve figured that out, your business advisers can help you to get the paperwork done. That paperwork typically includes:

Continuation Plan

While not necessarily a legal document itself, it becomes enforceable when the directors or officers of the corporation resolve to adopt it. The continuation plan should include who is to assume what responsibilities, who is to oversee the transition, what is to happen with loans that are personally guaranteed, key contacts at customers, suppliers, service providers, advisers, and creditors, insurance policy information, where business records are kept, and any other information that someone taking over your role will need to know about the business.

The continuation plan should be kept in the company’s minute book.

Shareholders’ Agreement

A shareholders’ agreement is a contract between the owners of a company as to how they’ll run the corporation. It can also force those who become shareholders in the future – perhaps resulting from your death or incapacity – to do certain things in running the business. I’ve talked about why you should have one for your business in an earlier article. I’ll write another one soon about what should go in to one… but the continuation plan for the death or incapacity of key people should be part of the shareholders’ agreement. If you have one in place already, work with your lawyer to make sure it jives with the continuation plan. If you don’t have one in place, it’s a good idea to make one.

Insurance

Though it’s not a purely legal issue, insurance is an enabler for most continuation plans. It’s common for the company or your co-owners to take out insurance on you, and the other main players in the business. There are a number of different types of insurance, each with strengths and limitations. The goal is to ensure that there’s cash available to tide the business over and find someone to fill in for the person that’s been lost. Each business will be different, and a good insurance agent can give you the full slate of options, and help you to choose one that works for your company.

It’s important that your insurance agent and lawyer get in touch to discuss the policy you’ve selected so that the legal documents mesh with the policy. Your lawyer can also help you to understand what’s covered, and what’s not under the policy. Once you understand where the gaps are, you can come up with ways to minimize the risks that remain.

Corporate Documents

Picking someone to step into your shoes is one thing. Giving them the lawful authority to make decisions in your place can be another one altogether. You should consider appointing the chosen one as an officer of the corporation, and giving them conditional authority to speak and sign to bind the company in legal documents. They should know where the corporate records are kept, and be put in touch with key advisers including the corporation’s lawyer, accountant, and insurance agent.

When the continuation plan is made, you should ensure that your business books and records are up to date and complete, including the minute book, government filings, and accounting records. Your successor will have enough to deal with already, without having to deal with figuring out what state the company is in first. The corporate minute book should also include a resolution approving the contingency plan, which will prove useful in dealing with outside institutions – banks in particular.

Wills & Domestic Contracts

Not only should you have a will in place that deals with your interest in the company, but it should be in harmony with the continuation plan. If the corporation has decided that your control of the business should pass to one person, but your will passes all of your property to your spouse, there’s a huge potential for conflict. Many people use separate wills for their personal and business assets. Domestic contracts – while painful to negotiate – can be used to protect control of the corporation as something that’s not included in the marital assets in the event of separation or divorce.

Powers of Attorney

A Power of Attorney for property is a legal document that authorizes someone to act for you in making decisions in the event that you’re incapacitated. Banks and other creditors will want to see this, possibly along with the resolutions authorizing the contingency plan and granting signing authority before they’ll deal with someone they don’t know. These are usually made or updated at the same time as your will.

Employment Contracts

Many owner-operators work without a written contract of employment in place with their company. It’s generally understood that as an owner-operator, your responsibilities and risks are almost indefinite. It is a good idea to put an employment contract in place with yourself – a description of duties, salary, and benefits at a minimum. This will help to set expectations for what’s expected of and given to your replacement.

A current employee who steps up into your role will be taking on a great deal more responsibility, and assuming more personal risk in the form of director or officer liability than they had before. This type of change to the employer-employee relationship is something that should be down on paper to protect both of you. Salary, responsibilities, and expectations may all change in the new contract. It’s also good practice to give some form of protection, called indemnity, to those who run the company.

If there’s nobody in your company who could step up to run it, a manager may need to be hired from the outside. If you want to have any say over their role, and any limits on their authority, you’ll have to set those out in advance. Again, the starting point could be your employment contract.

Again, insurance can be used to cover some or all of the expense of hiring, training, and paying a new employee.

Practicalities

Training your possible successor is the most important piece of the puzzle. They may show the potential to run the business by having the right skill set, but will probably need time to be brought up to speed on how the business works. It’s never too early to start. The up-sides of having someone who’s capable of running the business are many – you may even be able to take a holiday for once!

It’s also important to be mindful of avoiding trying to run the business from beyond the grave. A properly trained and equipped successor will still have their own ideas, and should have the flexibility to see them to fruition.

Conclusion

When a thorough continuation plan is made, it’s a major step towards peace of mind for you and your dependents. If you’re laid up with an injury or illness and the business founders without you, you may not be able to pay for your own care. If you pass away, and the business you’ve worked so hard to build follows closely behind, your dependents may be left high and dry. If the business goes under, your employees and others who rely on it for their livelihood, could be in dire straits. While it’s an uncomfortable thing to talk about and plan for, it’s the responsible thing to do.

I’m happy to help you start the process, and I’ve got a good team of specialists who can guide you through the finer points of tax, employees, insurance, and financial planning should you want the help. The next article, on how to plan for your retirement, will be on its way soon!

Now, to counter all those gloomy thoughts I’ve put in your head, here are some very cute animals trying to look tough.

See you soon…

 

 

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

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

Unanimous Shareholder Agreements

This can be a confusing topic. There’s a whole lot of stuff written about it, utilizing an abundance of excessively Brobdingnagian verbiage, but it’s usually a lot of talk about what a unanimous shareholder agreement (or “USA”) is, rather than why you might want one for your corporation. Here I’ll give you the basics of what it is, why you might want one, and what’s in it.

What is it?

A USA is a contract between all the shareholders of a corporation that limits the power of the directors to supervise or manage the business of the company. It could even take all management powers away from the directors. Without one in place, the directors can exercise all of the powers they’re given by the corporate laws, at the director’s discretion. Back in the day, if directors started running the company in a way that the shareholders didn’t like, there wasn’t much that the shareholders could do about it until it was time to vote for the directors again. Nowadays, the USA gives shareholders an out.

The rights, powers, and responsibilities that are taken away from the directors are then assumed by the shareholders. The shareholders will also take on the liabilities that go along with the powers – such as liability for unpaid employee wages, tax remissions, pension, environmental protection, etc. Some liabilities can’t be opted out of, such as the ones in the Occupational Health and Safety Act. Make sure you know the risks before signing on the dotted line!

A USA is a “constating document” of the corporation – like its articles and by-laws – that deals with the inner workings of the company. It is important to make sure that it doesn’t conflict with the articles or by-laws.

Once a USA is in effect, any new shareholders are deemed to be a party to it, and they should be given notice that it’s in place.

Why would I want one?

USA’s are most common in companies with a few shareholders, who own roughly even percentages of the company. They’re typically used to modify or supplement the rules in the Business Corporations Act:

  • Set out a Succession Plan: I’ll blog about succession plans soon, but a USA can be used to hand off the ownership and management of your corporation so that the business can continue after you retire, or if something bad happens to you.
  • Change Default Corporate Law Rules: such as the % of directors required to vote in favour of certain material decisions, such as paying dividends, buying or disposing of major assets, entering into joint ventures, non-arms-length transactions, mortgaging or liening property, or changing the business of the Corporation.
  • Protect Investor Interests:  venture capitalists, angel investors, or banks may want a USA in place to ensure that they can control things that directly affect their investment – such as amending the articles or by-laws, mergers, issuing new shares, or the sale of substantial company assets.

USA’s can also be used to do a few tricky things, which aren’t guaranteed to work out the way the shareholders intended.

  • Foreign-owned Corporations: the law requires at least 25% of directors to be resident Canadians. A USA can take all the powers away from the directors, and let the foreign shareholders do the decision-making. This may work for some purposes, but courts will ignore this sleight of hand in certain situations, particularly to do with tax liabilities.
  • Protecting Directors: where the shareholders own their shares through a holding company. Those holding companies assume the directors’ liabilities, and in theory, the people who own those holding companies are protected. It’s likely that a court would look right through this technicality though, if there wasn’t enough to pay out the creditors.

What’s in it?

Like any contract, the contents are up to the people making it. Typically, a USA may cover many of the following topics:

  • Decision making process
  • Quorum for meetings
  • Restrictions on share transfers, and how to deal with involuntary share transfers on death, bankruptcy, or court order
  • Special rights of minority shareholders, or special restrictions on majority shareholders
  • Process to amend the USA
  • Funding considerations – from existing or new shareholders, or
  • If the directors aren’t stripped of all of their powers – representation on the board, or a right to appoint someone to observe board meetings
  • Dispute resolution
  • Right to dissolve the corporation

There are plenty of templates out there that can get you started, including this useful one from the Law Society – but as I said above, it’s incredibly important to understand the risks before fiddling with the way your corporation is run…. like using a game of Operation to prepare for open-heart surgery.

If you need a lawyer, I happen to know a guy

Mike Hook
Intrepid Lawyer
Email: mike@intrepidlaw.ca
Twitter: @MikeHookLaw

Why does my corporation need a minute book?

In the hustle and bustle of running your business, record keeping often falls by the wayside. Most small business owners put corporate record keeping somewhere below “eating gravel” on their to-do list. The corporation’s minute book is often never even created in the first place, let alone kept up to date, even though the consequences of failing maintain one can be severe, and incredibly expensive.

Why do I have to?

Incorporating brings a lot of benefits – limited liability and tax being the biggest – but also comes with increased responsibility. The government has said, through the laws it has passed, that if you want the good stuff you’ve got to deal with the additional administration that comes with it. Whether you incorporated federally, or in Ontario, you must prepare and maintain corporate records. Trust me, it’s worth a little hassle and expense now to avoid greater hassle and expense later.

So what if I don’t?

Worst case scenario, your corporation could be found guilty of an offence under corporate law, and liable for a fine of up to $25,000.

Aside from the official penalty, there’s a great deal of business risk involved if your books are non-existent or out of date. I’ve often found myself playing CSI: Minute Book, going back several years to piece together the company’s history. It can take a fair bit of time and money to get it all figured out – neither of which small businesses have in spades.

There are a few common situations where your minute book will be in demand:

  • If you’re selling part or all of your company, the buyer will want to see the books as part of their due diligence – so they know exactly what they’re buying. Poor record keeping can drive the purchase price down, and the delay to get your books in order could put the whole sale at risk.
  • Most banks and other lenders will want to see your minute book before lending money to your business. They want to know that its affairs are in order, and the people they’re dealing with are authorized to act for the corporation.
  • Your accountant may want to see the minute book in preparing its tax returns. Without it, she’ll be forced to make assumptions on how to characterize the income, and may end up mis-reporting.
  • The Customs and Revenue Agency is entitled to inspect your books, and may do so as part of an audit of your personal taxes or the corporation’s taxes. This is more common if you’re paying yourself by dividends, or you’ve lent money to the company. The CRA could characterize money coming to you as personal income, tax the hell out of it AND deny the corporation the right to deduct it as an expense. Talk about lose-lose…
  • Shareholders, as owners of the company, have a legal right to inspect the minute book to know what decisions are being made.

OK then, what is it?

A minute book is really just a binder that holds the important documents of your corporation.

If a lawyer incorporated your business, they probably provided you with a minute book to start. If not, then you’ll have to prepare one yourself, including:

  • Certificate of Incorporation;
  • Articles of Incorporation;
  • By-Laws;
  • Consents to Act as Directors;
  • Director and shareholder resolutions
  • Minutes of director and shareholder seetings;
  • Registers of  the officers and directors;
  • Register showing the number of shares issued of each class of shares;
  • Record of the debt obligations of the corporation;
  • Stated Capital – the number of issued and outstanding shares;
  • Documents filed with government departments;
  • Share certificates, if used; and
  • The corporate seal, if used.

Then you’ve got to maintain the minute book, by keeping it up to date as the corporation does its business, including:

  • Resolutions from the annual meetings of shareholders and directors;
    • Electing directors each year;
    • Appointing accountants or auditors for each year;
    • Approving financial statements;
  • Records of loans to or from shareholders
  • Declared dividends;
  • Management bonuses paid;
  • Issuance or transfer of shares;
  • Changes in directors or officers;
  • Changes to how the corporation is run;

Can’t you just do it for me?

What’s tedious and boring to you is an adrenaline-fuelled rollercoaster ride of awesomeness for me. OK, maybe that’s a little extreme, but I’m happy to take the tedium off of your hands.  I can’t emphasize enough that it’s far far far far cheaper, easier, and less stressful to stay on top of this stuff than it is to go back and piece it together in an emergency – like when an investor or potential buyer wants to inspect your books.

Some clients like me to hang on to the record book and keep it updated when things change.  Others want to keep it themselves, and have me send them the updates when they make changes. Either way, this is one of those things that you shouldn’t waste your time doing…

Hey, you just read this blog,
and this is crazy,
but here’s my website,
so call me, maybe.

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

Non-Competition Agreements in the sale of a business

So, there I was, the dapper lawyer at the cocktail party, entertaining everyone with tales of legal derring-do. All were enthralled by my war story about finding a type-o on page 64 of a contract. “Tell us another!” shouted one. “Yes! Yes! Tell us a tale about something exotic! Something like… non-competition agreements!” demanded another, excitedly. I couldn’t help but to oblige.

Lucky for them, I’d just read the recent decision of the Ontario Court of Appeal where they’d just clarified the law about what makes a non-competition agreement enforceable after a business has been sold. (If you’re a nerd like me, you can read the whole decision here: Martin v. ConCreate USL Limited Partnership, 2013 ONCA 72).

This decision laid out the law on what makes for an enforceable non-compete agreement very clearly. Here are the basics:

  • We start with the presumption that a non-competition agreement is not enforceable, because it’s designed to restrict someone’s freedom to practice their trade.
  • Whoever is trying to enforce a non-compete has to show that it’s a reasonable agreement between the parties.
  • Non-competes in the sale of a business will be less scrutinized than those between employers and employees, as there’s usually equal bargaining power in a sale of a business.
  • Agreements that are signed by people who had legal advice on the agreement before signing it are more likely to be enforceable.
  • Just because it’s a sale of a business and both parties had legal advice doesn’t mean that an unreasonable agreements will be enforceable
  • A reasonable non-competition agreement will be clear, and unambiguous in three major areas:
    • The geographic scope, or area in which the non-compete applies, must be defined clearly
    • The time period that the agreement covers must be reasonable, and have a clear start and end point – and not be tied to a future event that is outside the power of the parties to control (or may never happen…)
    • The activities that are prohibited must be clear and reasonable – only what’s necessary to protect the business interests of the purchaser

A non-compete is a valuable tool to protect a new purchaser from having to fight for business against someone who has insider information on how the purchased business is run. Theoretically, if the vendor is allowed to start a new business in the same area that’s a little leaner, they could undercut the purchaser and put them out of business. The non-compete is designed to prevent this – but is only to the minimum extent necessary.

Of course, I explained to the spellbound crowd, what’s “reasonable” in any case really depends on the circumstances. Non-competition agreements or clauses are the type of thing you should get legal advice on before sticking them in any agreement – especially the sale of a business!

I’m available for legal advice or children’s parties, should ever you need me.

Happy Thanksgiving!

Mike Hook
Intrepid Lawyer
mike@intrepidlaw.ca
@MikeHookLaw

How do I structure my business?

One of the most common questions I get from entrepreneurs at networking events is how to structure their business. Actually, the conversation usually starts with a question about whether or not I “do incorporations” (the answer is yes, btw). It seems most people have an idea that there are advantages to incorporating, even if they don’t understand what the advantages may be.

The short answer is yes, there are some advantages to incorporating, but there are many ways to skin the business structure cat. Before you make up your mind that the corporate form is right for you, you should know what your other options are, and what some of the advantages and disadvantages are.

So, without further ado, here are three of the most common business structures in Ontario:

The Corporation

When you incorporate, you’re birthing a separate “legal person” that has many of the same rights and responsibilities as an actual person. It can enter into contracts, borrow money, sue and be sued, pay taxes, and even has some rights under the Charter of Rights and Freedoms. It is owned by its shareholders, and run by its directors and officers.

The biggest advantage of incorporation is “limited liability” – meaning that if someone has a legal dispute with a corporation that you own, your personal exposure isn’t more than the assets you’ve invested in the company. (This isn’t true 100% of the time – see this article on director & officer liability). Another advantage is that the corporate tax rate is much lower than the individual tax rate. A good accountant can work with your lawyer to set the business up in a way that minimizes your business and personal tax costs.

Other advantages:

  • It continues to exist even if the shareholders, officers or directors move on or pass away.
  • Ownership can be sold or transferred in whole or in part.
  • Easy to raise money (capital) by selling shares or options for shares.
  • There are clear rules on the roles of the people who control and operate the company.
  • Corporations can be shareholders (owners) of other corporations, which can further protect the people who ultimately own the companies from liability.

Disadvantages:

  • Extensive record keeping and annual reporting requirements to the government.
  • More involved process to take money out of the corporation to pay yourself.
  • Possible disputes between shareholders and management.
  • Higher startup costs than other business structures.

Well Suited For:

Industries with more risk of being sued, that are more likely to need outside money to grow, and where hiring employees or contractors to run parts of the business is likely, such as:

  • Manufacturing
  • Retail, bars & restaurants
  • Construction & landscaping
  • Resources
  • Transportation, tourism & adventure
  • Tech services and support

A corporation is a very flexible business structure that, if set up correctly in the first place, can grow and change with your business as it evolves. If you’re considering setting up shop as a corporation, give me a call, and we can make sure we get it done right.

The Sole Proprietor

This isn’t much more than you registering a business name, and starting to do business. You and the business are the same person for legal and tax purposes, so anyone who is owed a debt by the business could claim against your house, car, or personal savings to get it paid back.

Advantages:

  • Simplicity
  • Very little startup cost
  • Little government regulation
  • You have direct control of decision making
  • Business losses can be deducted from your personal income

Disadvantages:

  • Your personal assets may be at risk.
  • Higher tax rate on business income means there’s less to reinvest in the business.
  • Banks and other lenders may be less willing to make loans.

Well suited for:

Low-risk industries, remote/virtual workers, consultants, and services for individuals rather than businesses, such as:

  • Social media
  • Personal training
  • Bookkeeping
  • Professional services and other consultants
  • RMTs
  • Web design

A sole proprietorship is a cheap and easy way to get your business off the ground. It’s not particularly flexible, or well suited for long-term growth, but it’s not difficult to incorporate a business later once you’re ready to grow, hire, rent space, and enter into contracts with suppliers and customers.

The Partnerships

A partnership is an agreement, typically in writing, between two or more people (or corporations) to carry on business together for mutual gain. You pool your resources, and share in the profits or losses according to your agreement. No separate legal person is created – so creditors can still look to the partners’ personal assets to satisfy debts owed by the partnership. Partnership income is paid out to the partners, and you’re each taxed at your individual rate.

Limited Liability Partnerships are ones in which the other partners aren’t liable for the debts or claims against one of the partners. Law firms and accounting practices commonly use this form.

Limited Partnerships ones where all partners own the assets of the business, but certain partners limit their liability to the value of their contribution to the partnership. At least one of the partners must be a general partner, with no limited liability.

Advantages

  • Simple to start up.
  • Very flexible, and can allow each partner to keep control of their portion of the business
  • Few ongoing formalities such as annual meetings
  • Business losses can be deducted from your personal income.
  • Costs and profits are shared between the partners

Disadvantages

  • Your personal assets may be at risk
  • You are legally and financially responsible for business decisions made by your partner – such as entering in to bad contracts, or breaking them
  • Income is taxed at your personal rate
  • Possibility of conflict between partners
  • Higher start-up cost, as all partners should have independent legal advice in negotiating and drafting the partnership agreement.

Well Suited For:

Diverse groups of professionals working towards a common goal (pooling resources), people cooperating on short-term projects, and projects in exploratory or preliminary phases in:

  • Professional services – accounting, architecture, real estate, medicine, incubators/accelerators
  • Industrial or real estate development
  • Mining projects
  • Arts, theatrical and film ventures
  • Medical, scientific and technology research

Since a partnership is a private agreement between the partners, it can be adapted to suit just about any relationship. If you’re considering entering in to a partnership, you should have legal advice to make sure that you know what you’re agreeing to, and that your interests are protected. More information on partnership agreements is coming soon.

Hopefully this article helps you to understand what your options are, and gives you an idea of how to get your business off the ground. I’m happy to discuss these options with you, and help you get your business set up for long-term success.

 

Mike Hook
Intrepid Lawyer
mike@intrepidlaw.ca
@MikeHookLaw