Many successful small business owners may eventually find themselves in a financial position where they’re looking to explore new investment opportunities—all while protecting their assets and mitigating risk.
Why not start by investing in yourself? One of the best ways to invest in a new opportunity while protecting your personal and business assets, and to mitigate risk, is by starting a holding company.
Holding companies can offer many benefits, such as tax savings, asset protection, having more control with less investment, and the ability to retain original management when the holding company gains a subsidiary.Today, let’s do a deep dive into everything you need to know about holding companies—what they are, how they work, the 4 different types, their advantages and disadvantages, and how to know if one is right for you.
What is a Holding Company?
A holding company differs from an operating company, whereas the holding company exists solely for holding investments and assets like shares, stocks, real estate, and even patents.
A holding company doesn’t do any business actions like buying or selling products or services. Its primary goal is to have control—either by forming a partnership or having ownership of another business or businesses.
How Does a Holding Company Work?
Corporations can become holding companies in one of two ways:
- Acquiring the needed shares or stock in a company to gain enough power to have control over its business actions
- Starting a new corporation from scratch and keeping all or some of its shares
A parent-subsidiary relationship is when the mother company (parent company) has a relationship with the corporations they control (subsidiary). When the parent company has control of all shares and voting stock of the subsidiary, it’s classified as wholly owned by the parent company.
When a corporation owns over 50% of the shares or stock of another company, it ensures having greater control over its business actions, but a parent company can still have a say in the business actions owning as little as 10% of its voting stock.
What is an Example of a Holding Company?
A good example of a holding company is Berkshire Hathaway. They have major holdings in some well-known subsidiary companies like Dairy Queen, Duracell, GEICO, and Fruit of the Loom.
Types of Holding Companies?
Now that you know what a holding company is, let’s dive into the 4 different types:
- Pure: A pure holding company’s only purpose is to own and have control of the voting stock and shares of other companies. It doesn’t engage in any other business transactions, like the buying or selling of products or services.
- Mixed: Mixed holding companies still have control of their subsidiaries, but also take part in either its own business operations (it’s then called a conglomerate) or the business of its subsidiaries (also referred to as a holding-operating company).
- Immediate: Immediate holding companies still hold voting stock and have control over another company, but that company is already a subsidiary to another company.
- Intermediate: Intermediate holding companies are subsidiaries to their own holding company, but in fact, have control over another company.
What Are The Advantages and Disadvantages of a Holding Company?
There are many perks to having a holding company—receiving tax-free intercorporate dividends from an operating business, adding an extra layer of protection between the operating company and the shareholder in the case of litigation against the operating business, and the potential to invest excess profits. But not all companies will benefit from having a holding company.
Check out these advantages and disadvantages:
Tax credits—what every business owner loves to hear. In Canada, dividends from corporations can move between companies tax-free. When a holding company receives the dividends instead of individual shareholders, it’s held tax-free. Shareholders can keep the earnings in the holding company until a later date or when they are in a lower tax bracket, such as after retirement.
If at least 80% of all subsidiaries are owned by the holding company, a consolidated tax return can be filed. Combining all finances from every company, including the parent company, will reduce tax liability and offset any losses that an underperforming subsidiary may have encountered.
When selling shares of your company, a holding company allows you to take advantage of the Lifetime Capital Gains Exemption (LCGE)—but there are a lot of criteria that need to be met to qualify for this exemption. Just a few of those criteria are:
- The company has to be Canadian-controlled
- It also has to be a private corporation
- A minimum of 90% of its assets owned before sale of shares
The holding company may allow you to meet these requirements, but since there’s so many criteria to consider, it’s best to seek professional advice to help determine if you qualify.
Dividing The Income:
Having a holding company in place allows you to split or divide your income. This is especially popular amongst family-owned businesses. When you pay dividends to the holding company, your shareholders can decide who receives the income. When family members apply for shares in the holding company, the tax burden can be lessened by splitting the income between people in different tax brackets.
Having a holding company in place protects your assets. When an operating business faces liability issues or goes bankrupt, its creditors can fight for its assets. Just one claim can put a lifetime of profits at risk for small or medium-size businesses.
When you move investments, excess earnings, and other assets to your holding company, they become separate from the main operating business, which makes them untouchable to creditors if something like bankruptcy or liability issues were to happen.
The separation between the holding company and the shareholders and operating business can also help protect any assets that you own personally, like your house or vehicles, if litigation issues were to arise against the operating company.
More Control With Less Investment:
A holding company only needs to purchase 51% of a company to gain control of its interests. This allows small business owners to purchase multiple companies and take control of them with a smaller overall investment.
Retain Original Management:
There usually isn’t a change in management when a holding company gains a subsidiary. Holding companies normally don’t take an interest in the day-to-day activities unless there’s a need for strategic decision-making or performance evaluation. In maintaining the original workforce, the owner of the holding company financially benefits by not having to look for replacements or by adding to their own duties and managing it themselves.
Set Up And Compliance Costs:
The biggest disadvantage of having a holding company is the ongoing compliance and initial set-up costs. Along with the incorporation fee, there are ongoing compliance expenses, like:
- The cost of your financial advisor
- The cost of preparing monthly financials for your shareholders
- The cost of filling corporate tax returns
For a holding company to be the right move for your business, your shares should be worth a high enough value that you don’t know what to do with the excess money. It’s always best to speak with a financial advisor before making the final decision—in most circumstances, the benefits outweigh the compliance costs.
The Potential Loss of the LCGE:
The limit of the tax exemption as of 2021 for a Qualified Small Business Corporation (QSBC) is $892,218 CAD. But without a good financial advisor who knows all the ins and outs of the LCGE, you could end up losing the ability to claim it. Your advisor should know when to “purify” the corporation (when to set up a holding company) so you can meet maximum limit requirements and meet the following requirements:
- Must own 90% of the company from which you plan to sell shares in
- You must have held those shares for a minimum of 24 months
- Over 50% of those shares had to be used in an active business
How Do I Know if a Holding Company is Right For Me?
Without speaking to a financial advisor, the short answer is—it all depends on what your objectives are:
- Is your company earning extra money that you’d like to invest to offset some taxes?
- Is your company part of an industry where the litigation risk is higher?
- Do you have significant personal assets that you’re looking to protect?
Are You Thinking About Setting Up a Holding Company?
Creating a holding company for your Canadian small business can be very beneficial. The tax savings and asset protection alone make it worthwhile—if you’re in the right position to do so.
As glorious as setting up a holding company sounds, don’t forget about its disadvantages. With all the tax-related decisions and legal matters involved, the decision to start a holding company isn’t one you should make on your own.
Protect yourself and your investments by speaking with a qualified financial advisor to be sure that a holding company is right for you.
Let’s grow and protect your wealth together. Book a free consultation today to get started.