The Benefits of a Holding Company

Introduction

Holding companies, also known as portfolio companies or management companies, offer SMEs (Small and Medium-sized Enterprises) and entrepreneurs an effective way to maximize their tax benefits in the short or long term.

By strategically planning the timing of their taxation, businesses can reduce their taxes and invest more money into their company. In this article, we’ll examine some of the tax benefits offered by a portfolio company, as well as how they can help an SME strategically plan taxation.

What is a Holding Company?

A holding or portfolio company is a company that will hold shares in the operating company. A company that engages in sales, offering products or services to its clients, is considered the operating company.

The Holding company is also subject to taxation and regulations, and it comes with its own advantages and disadvantages.

A holding company is used to consolidate passive income (investments, interest, dividends, etc.) and to defer personal taxation onto it.

How Much Does a Holding Company Cost?

The fees of a management company can be summarized in three categories:

1. First, there are business incorporation fees, which generally cost between $1,000 and $2,000. 

2. Then, there are the fees for a tax specialist. This specialist will transfer the shares held by an individual to the holding company, fill out forms and government choices, and thus avoid any tax impact during the transfer.

3. And finally, there are maintenance fees, such as accounting, legal, tax services, annual registration fees. These can cost you from $2,000 to $4,000 per year.

To decide if a holding company could be beneficial for you, you should calculate the financial costs incurred against the potential gains you could derive from it.

The Advantages of a Holding Company

Here are some potential advantages of a holding company:

Asset Protection 

A holding company that holds more than 10% of the operating company, which is conducting the main business activity, can receive tax-free dividends from the operating company.

Therefore, the liquidity of the operating company will be transferred to and safeguarded in the holding company. This provides the operating company with protection against risks, such as legal action taken against the company, bankruptcy, or market fluctuations.

If there was no holding company, the entrepreneur would receive the dividend and thus be subject to taxation.

Income Distribution Over Several Years 

As discussed in our article How to calculate your taxes, personal income tax rates increase based on the taxable income amount in the year. Therefore, if you earned $100,000 in one year and $0 the next year, you will pay more tax than if you’d earned $50,000 for two consecutive years.

With a holding company, you can withdraw liquidity from the operating company and impose a uniform tax strategy, thus avoiding spikes in taxation.

Avoiding Taxation for Shareholders 

If more than one shareholder owns an operating company, it’s beneficial to establish a holding company between each shareholder and the operating company. This will avoid creating issues in the distribution of the operating company’s assets.

 Let's take an example of a company with two shareholders, each holding 50%. Mr. Spender always wants to receive dividends from the operating company to spend them personally, while the second shareholder, Mr. Saver, wants to keep his money sheltered from taxes for as long as possible to let it grow.

With the two management companies, the operating company pays a dividend, and the shareholders can decide whether they want to be taxed immediately or keep their savings sheltered from taxes within the holding company, thus earning investment income on these funds.

Nothing prevents a shareholder with a management company from using the accumulated savings to invest in another operating company.

Use as a Financial Branch

Another advantage of a holding company is to mentally separate the operations and financing of the operating company. The operating company must be profitable and generate profits for its shareholders. If funds are transferred from the operating company to the management company, the latter becomes the guardian of the group's liquidity. Then, if the operating company faces liquidity and profitability issues, instead of watching its funds dwindle, it can request a transfer of funds from the management company.

This structure will give shareholders the opportunity to assess the liquidity issues and consider the amount they are willing to reinvest in the operating company. In other words, the holding company will be the banker of the operating company. Like a bank, it must do its due diligence and anticipate its short and medium-term liquidity needs. Additionally, it’s important to explain the methods that the operating company plans to implement to regain profitability when requesting funds.

Streamlining for Capital Gains Exemption

When selling a company, if they meet certain criteria then the seller may be entitled to a capital gains exemption on the sale of small business shares, up to an amount of $971,190.

One of these criteria is that, on the date of the transaction, more than 90% of the company's assets are used to earn business income, and for the preceding 2 years, more than 50% of the assets have been used to earn business income.

Therefore, excess cash or investments that are intended to generate investment income must be regularly withdrawn from the company. Additionally, the company must be streamlined (by withdrawing surplus cash) by the date of the transaction to comply with the 90% threshold.

The holding company can be used for this streamlining, with no personal tax impact.

Tax Planning

As we have often discussed, in taxation, there are 3 Ds of tax planning:

1. Divide: By sharing ownership with your spouse, you can split income between more than one person and thus reduce your tax burden.

2. Defer: By paying a tax-free dividend into the holding company, you can defer the taxation of the amounts withdrawn from the operating company. Then, you can invest them tax-free in the holding company and earn investment income.

3. Deduct: You can deduct expenses from the holding company, such as accounting and tax fees, as well as costs of a home office.

When tax planning, you can use one or more holding companies to increase tax-saving opportunities. In some cases, particularly when you are planning on selling your company, a trust can be used to maximize opportunities for multiple capital gains exemptions.

Control of an Operating Company

Holding companies are often used to bring in some new shareholders without losing control of the operating company.

For example: My holding company owns 51% of the voting shares of an operating company, and I hold 60% of the share capital of the holding company. So, I actually only own 30% (60% of 51%) of the value of the operating company. However, I still control the operating company because I have the majority vote in the holding company, which, in turn, has the majority vote in the operating company.

Another common example: There are two shareholders who want to involve their spouses in the profits of their operating company. However, they may or may not want their spouse to be part of the ownership of the operating company. By creating a holding company, the co-shareholders can bring their spouse into their own holding company. Then, they can engage in tax planning as a couple by splitting the income.

In Conclusion…

A holding company is almost always used in tax planning or to protect the liquidity of an operating company. Before creating a holding company, conduct a cost-benefit analysis, considering both tangible and intangible advantages, and make an informed decision.

As always, if you have any questions, please feel free to contact us.