Corporate Structuring & Holding Companies
Today, an entire industry revolves around corporate structuring, asset protection and tax planning to ensure individuals are removed as far as possible from findings of personal liability, while at the same time, lawfully reducing or deferring tax obligations. Absent the use of a holding company, there are three main reasons startups incorporate:
1. Reduce Exposure to Personal Liability – The main reason most founders incorporate is to protect their personal assets against the claims of creditors and lawsuits. Without incorporating sole proprietors and general partners in a partnership can be personally and jointly responsible for the liabilities of a business including (among other things) loans, accounts payable and legal judgments. In a corporation, however, shareholders are typically not liable for the company’s debts and obligations. With some exceptions, shareholders are usually limited in liability to the amount they invested or loaned to the corporation.
2. Tax Benefits – The second reason founders incorporate is to take advantage of tax savings. Corporations, like individuals, are subject to both federal and provincial income taxes. However, corporations are taxed differently . While individuals are subject to progressive income tax rates, corporations are subject to flat rates of tax. The rates of tax applicable to corporations are lower than most individual tax rates.
3. Raising Money to Finance a Business. The corporation is also the best vehicle for raising money to finance a business. However, given the complexity of securities laws, its best to hire a lawyer to help you issue shares. Remember that as a startup you cannot head out into the market and issue shares to whomever you desire. Speak with a lawyer for assistance.
Aside from the three main benefits, other benefits of incorporating include:
- Transferable ownership. Ownership in a corporation is easily transferable to others by selling all or part of your equity (subject to applicable laws).
- Durability. A corporation is often capable of continuing indefinitely and does not dissolve on the death of shareholders, directors, or officers.
The Holding Company
Holding companies can further reduce risk, minimize tax and be an effective estate planning tool.
From a liability perspective, building large cash reserves inside your operating company makes you a litigation target. There is a saying in the legal community that “litigation is the search for the solvent defendant”. In short, only defendants with money (or a good insurance policy) tend to get sued. By using a holding company, profits can be extracted from your operating business (often as dividends). So if you operate a business that has the risk of being sued one day, holding companies can (with some exceptions) be used to reduce your litigation exposure.
Once funds are paid out of your operating company as dividends, your holding company can sometimes use the money to purchase investments such as real estate, other businesses etc. Often (although not always) assets purchased by the holding company can be leased back to the operating company while still not exposed in a lawsuit against the operating company.
From a tax perspective, business owners can consider a holding corporation as a private pension plan. In some cases, the shareholders can transfer funds into a holding company during high earning years, and withdraw profits later, often when they are taxed in lower brackets. However, holding companies do not always make sense for tax purposes. For example, they present the risk of missing out on other tax benefits arising from simple corporate structures. So make sure you discuss the pros and cons with your tax advisors. It is always best to obtain accounting and tax advice early in your corporation’s existence.