In The Law for Founders, we explored the risks related to ensuring that your corporation is actually a separate legal entity from you, as the shareholder. Those same risks apply whether you hold ownership of your company individually, or via another ‘holding company’ or ‘holdco’. In that section, we covered the ‘alter ego’ doctrine, as one of the grounds for finding that either you personally, or another corporation you control, could be liable for the debts, duties and obligations of your operating company.
In a separate section in The Law for Founders (Quick Notes on Corporate Structuring), we explored that some founders use intellectual property holding companies, where IP is held by one company and licensed to one or more operating companies.
There are endless types of corporate structures, and various reasons for why those structures are put together, IP holding companies being one of them. Based on other objectives, there are other types of holdco structures that may be put in place. The structure that is right for you may depend on whether you are optimizing for tax planning, the sale of your business, attracting investment from third parties, estate planning (passing your business to another generation) or even asset protection.
For example, one use may be for business owners to regard a holdco as a private pension plan. The owners can accumulate funds in a holding company during high earning years, and then withdraw these funds when they are required, often when they are taxed in lower brackets.
Aside from using separate entities for holding intellectual property, holding companies (whether they hold cash, investments or shares of subsidiary companies, can, if done properly reduce risk, minimize or defer tax (in some situations) and be an effective estate and asset protection planning tool.
However, there is no one-size fits all solution. If you plan to use a holding company, or a particular corporate structure, speak with an accountant and lawyer first to understand the pros, cons and risks in your circumstances. Choosing a structure and even implementing a structure incorrectly, can not only be counter-productive, but it can also end up achieving the opposite of what you intended; resulting in increased tax and exposed assets.
More complex corporate structures also include the use of family trusts. At the time of writing, family trusts are primarily used in an attempt to allow family members to take advantage of the lifetime capital gains exemption in the event your company is sold. However, that may not be the case at the time you read this.
That said, it is not uncommon, from a liability perspective, for professional advisors to want your operating company, once (or even before) it has sufficient operating capital and cash reserves, to distribute the cash to a holdco.
In Canada, in certain circumstances and for qualifying companies that are “Canadian Controlled Private Corporations”, the distributions of profits up to a holdco may be able to be done on a tax deferred basis. The holdco can then either pay you a dividend when you personally need the cash (which you would be taxed on), or use cash accumulating inside the holdco to reinvest in other businesses, public markets, real estate or other ventures. Again, make sure you obtain tax and legal advice to confirm what the implications are in your circumstances.
If one or more of your operating companies requires part of the cash distributed to the holdco, at a later date, subject to tax rules, you can always look at lending the cash back to the operating company. Ideally, this would be done with a registered security interest over the assets of the business (see the chapter above on “Founder Loans and Understanding Promissory Notes and General Security Agreements”).
Such loans should also be done formally in an agreement, in compliance with applicable law, any shareholder and other agreements in place. Keep in mind that there can be tax rules (and negative tax consequences) around such loans, and their repayment. Before making any such loans, they should be coordinated with your accountant and lawyer. For example, there is a risk that loans from a holdco back to an operating company could be characterized as a shareholder benefit or a deemed dividend, which could have tax implications. Again, get specific advice on this from a lawyer and accountant based on your circumstances.
From a liability perspective, there is a saying among lawyers that “litigation is the search for the solvent defendant”. Defendants with money and assets (or a good insurance policy) are more appealing litigation targets. I have said elsewhere that nothing attracts litigation more than a business with financial success. For some, their planning involves moving excess cash, that is not required for the operation and growth of the business, to a holdco or another entity that can be used for investment and other purposes, instead of using or investing that cash directly from within the operating company.
Of course, this decision is one that gets made by a board of directors, so if you are not the sole director, it is a decision by the board as to whether there is excess cash, and if so, whether it will be paid out to the shareholders.
While many growth companies won’t pay a dividend, because they reinvest cash back into their own business to accelerate growth, businesses that accrue excess cash on the balance sheet leave that cash exposed to lawsuits, judgments and claims against the business. For this reason (and obviously to reward shareholders for their investment) dividends may be paid out on a regular basis.
However, under Ontario law, and other provinces, you cannot transfer assets out of an operating company, or even pay dividends, where (i) the company is insolvent (and possibly even when the company is in the ‘air of insolvency’ (i.e. close to being insolvent); or (ii) where the payment or distribution was made with the intent to defeat or hinder a creditor who is owed money or assets. In that respect, section 2 of the Fraudulent Conveyances Act (Ontario) says:
“Every conveyance of real property or personal property and every bond, suit, judgment and execution heretofore or hereafter made with intent to defeat, hinder, delay or defraud creditors or others of their just and lawful actions, suits, debts, accounts, damages, penalties or forfeitures are void as against such persons and their assigns.”
This means that if part of your planning, in having a holdco, is to have a place to invest cash (possibly) outside the reach of judgment creditors, dividends should only be paid where there is no ‘intent’ (or even the risk of a perceived intent) to defeat a creditor. For some, this means their operating company profits are paid to shareholders on a regular basis, following a duly passed board resolution, as and when excess cash is available. This can avoid the risk of your operating company panicking and transferring lump sum amounts, potentially violating the Fraudulent Conveyances Act, at a time when there may be a claim or threat of a claim against the company.
With that in mind, before you undertake any corporate structuring work, or the distribution of assets or dividends out of the company, make sure your lawyer advises you on how the Fraudulent Conveyances Act (and similar legislation in other provinces), may impact your structure, the ongoing operation of your company and the distribution of profits.
Your lawyer and tax advisor may advise you, in your circumstances, that it would be a good idea to regularly distribute excess cash, in regular intervals, to try to avoid the problem of claims or potential claims arising before the payment of dividends or excess cash is made. As mentioned, in those situations, the payment of dividends could be unlawful. Similarly, there is a risk that if done improperly, creditors could seek to unwind any payments your operating company makes to your holdco, or worse, seek an order from a court that the holdco is, in effect, one in-the-same entity as your operating company for the purpose of liability.
I know I have been relentless on the point to get legal advice in this area, before you undertake any form of structuring, but I will reiterate it again. Why? There are very important rules and case law to follow, as guidance, for how to properly operate both your holdco and the related operating company in various situations, to assure (i) they are not making distributions that could be unwound, (ii) they are not commingling assets (a risk under the alter ego doctrine) or (iii) otherwise taking risk of being found, by a court, to be one in the same entity for the purpose of liability. Very careful legal advice should be sought to ensure you are setting up and operating your holdco entirely separately and that it is legally distinct from the operating company.
You should equally obtain tax advice as the use of holdcos can also have negative tax consequences and complicate a share sale transaction if you intend on selling your operating company one day.
DISCLAIMER: The information in this article is not (and is not intended to be) legal advice. This is legal information only. Reviewing information about the law may help you understand whether you need legal assistance. Whether and how this information applies to your circumstances requires the assistance of legal counsel who can apply the information to your needs. Do not rely on this article to make decisions. You may contact Wires Law, and we would be pleased to determine whether our firm can assist you. No solicitor-client relationship is established until we confirm we can act for you in a legal services agreement. Read our Terms of Use for more information.
John Wires
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