Creditor-proof a client’s company

While traditionally structured to hold an operating company’s shares, a holding company also allows creditor proofing of after-tax earnings, and provides a vehicle to invest excess cash.

The creditor proofing is achieved by converting unsecured after-tax corporate earnings into a secured shareholder loan that’s placed in the hands of the holding company. It then defers payment of tax over and above the corporate income rate, which may be as low as 15%.

If the operating company holds excess cash, consider investing it in the holding company for accumulation there, rather than loaning it back to the operating company. Although tax on corporate investment income is significantly higher than business tax rates, this strategy still allows an owner to manage his or her tax rate more effectively.

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Problems can occur with this structure when it’s time to sell the business. The lifetime capital gains exemption of $750,000 for each family member is only available to people, not companies. So owners will have to sell the shares of the holding company in order to access the $750,000 exemption on the sale of shares.

ROBERT WONG*, AGE 45, owns a successful flooring company. A family trust with a holding company beneficiary structure was set up two years ago. The $300,000 that would have been sitting in his operating company’s bank account, exposed to creditors, is now in the holding company. Wong is also investing in several private mortgages, and looking at financing a new business venture. Had he taken that cash personally, he would have paid $95,000 in tax, leaving him with considerably less money for those investments. His two children and his wife are also beneficiaries of the trust, so when the business is sold, $3 million of the proceeds could be tax-free by virtue of having four $750,000 capital gains exemptions as opposed to one. This will save Wong’s family $522,000 in taxes. *Name has been changed

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Obtaining the capital gains exemption also requires a number of conditions be met—including the proportion of the value of assets used in an active business as compared to non-active assets—and purchasers may not want the non-business investments either. With significant investment, or non-active holding company assets, you may be offside for the capital gains exemption, wasting hundreds of thousands of dollars of potential tax savings.

So what’s the solution?

A discretionary family trust may solve the problem. Rather than having a holding company own the operating company’s shares, a family trust can be established with beneficiaries including you, your spouse, and your children. In addition, a corporation can be a trust beneficiary.

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With this structure, not only is the capital gains exemption preserved, but you may be able to multiply it across a number of individual beneficiaries, all the while having access to the creditor proofing and excess cash investment opportunities.

Jordan Gould, CPA, CA, is a partner at Richter LLP in Toronto.