Protecting Corporate Assets
In this three-part series, Lott and Company outlines initiatives that you can proactively take now to protect and safeguard against future threats to corporate assets and retained earnings of your company.
If you have not yet reviewed part one where we covered the advantages and limitations of using shareholder loan structure, we encourage you to read it here.
The purpose of holding companies is often misunderstood. They do not receive special tax treatment. The primary purpose is to protect retained earnings and valuable operating assets from unsecured creditors of an operating company.
Many business owners will take the simple approach and just have their operating company purchase a new building or equipment. This keeps accounting and administrative costs to a minimum and is sufficient if there is never a financial crisis in the company. However, a problem could arise if something does go wrong in the company. The building or equipment could be lost to creditors if there is a large liability that cannot otherwise be paid.
If you are purchasing a building to operate your business from or valuable equipment that is significant to the operation of your company, a holding company should be considered. The holding company would then rent these assets to the operating company and protect them from unsecured creditors of the operating company. The holding company would not have any creditors other than a lender that financed the purchase of these assets.
Another potential problem with owning a building in the operating company arises when it comes time to sell the business. You may want to keep the building and earn rent from it, potentially as a retirement asset. Also, the buyer of the business may not even want to buy the building. This can make the sale of the business more difficult and likely prevents the sale of the shares of the company. Retaining real estate assets in a holding company can simplify and enable a share sale of your business.
In addition to simply charging rent for the use of these assets, a properly structured holding company needs to have a mechanism for getting cash out of the operating company. To do this, the holding company needs to own shares of the operating company to allow for dividends to be paid to the holding company.
Declaring dividends to the holding company allows for the retained earnings of the operating company to be moved to the holding company and away from the grasp of potential unsecured creditors. This works even if there is no excess cash to pay the dividends. As noted in part one of this series on shareholder loan structures, the dividends can be paid through the issuance of a promissory note and the holding company can then register security for the promissory note to ensure that it is paid before any unsecured creditors.
The benefit of this structure is that dividends can be paid from the operating company to the holding company with no tax. Under Canadian tax law, there is no additional corporate tax when moving tax-paid funds within a corporate group. There is no further tax payable until the funds are removed from the corporate group by declaring dividends to the individual shareholders.
This allows for excess cash to be safely invested away from creditors of the operating company and used to build a retirement fund, to grow a fund for future investment in the business operations, or to purchase valuable business assets that will be required in the future. The COVID-19 pandemic has shown many business owners the need to have a financial cushion should something unforeseen occur in the business.
The greatest benefit of a holding company is that a larger amount can be invested because the personal tax has been deferred on the dividends that would have been otherwise taxed personally. To provide an example, assume that the operating company has $100,000 of excess cash to protect from creditors after corporate tax is paid. Also assume that the business owner already has $150,000 of personal income. If they were to withdraw this amount as a personal dividend, they would pay personal tax at a rate of approximately 43% on that excess cash or $43,000. This would leave them with only $57,000 to re-invest in their business or to invest for their future. Using the holding company structure, they would continue to have $100,000 to invest.
It must be noted that when using a holding company structure, consideration must also be given to the future potential sale of the shares of the operating company and the impact on the tax-free benefit of the Lifetime Capital Gains Exemption (LCGE) on qualifying small business corporation shares.
Accounting and legal assistance is necessary to set up a holding company structure for an existing operating company to avoid triggering tax on the transfer of operating company shares to the holding company. Lott & Company can assist you with assessing the benefits and costs of this option.
In the upcoming final part of our Lott & Company three-part “Protecting Corporate Assets” series we will discuss the considerations in using a family trust structure and how this structure can set your business up to capitalize on the LCGE.