Holding Companies

David Herron came to see me last week. He had read some of my columns on retirement planning and they had grabbed his interest.

David explained that he founded Herron Consulting Engineers Inc. 15 years ago. He was about to celebrate his 62nd birthday, and he thought it was about time he began to think about what would happen to his company and his finances as he began to work less. He also told me that the company had eight employees and pretax income of $400,000. David said he needed about $200,000 to live on. He invested the rest.

“How much money do you have saved now?” I asked.

“About $500,000. Most of it is in mutual funds. I’ve been saving for five years. Before that I was putting kids through school and I couldn’t set aside much money.”

While David was explaining this, I reviewed the company’s financial statement. That’s when I had a surprise. “I see there’s no taxable income in the company. And the corporation’s retained earnings are $75,000, which is the amount of your receivables and fixed assets.”

“That’s right,” David said. “I pay myself a bonus — which means the company earns no taxable income. That keeps my corporate taxes low and it removes my assets from the business.”

“I see,” I said. “You deliberately invest your cash outside the company. Are you aware that’s a very expensive course of action? When you take a bonus from the company you pay tax at the full personal rate on it.”

“We engineers are liable forever for the work we do. One day my company is likely to be sued. Naturally I have insurance, but I don’t want to leave assets in the company where they’ll be exposed to a plaintiff.”

“That makes sense,” I said. “But the way you’ve done it is terribly expensive. If you left profits in the company, the corporation would pay tax on it at only 18%. You are paying personal tax at 46%. For every $100 you bonus out to yourself in excess of your living needs, you get to keep only $54. If you invested the same money within the company, you’d be able to invest $82. That’s an increase in retention of $28 per $100. Your after tax retention would be over 50% higher. You’d save more much faster.”

“That sounds good on the surface, but money in the company would be exposed to creditors. It doesn’t help me to pay less tax if I lose everything I own in the courts.”

“Of course,” I replied. “But you can safeguard your cash against lawsuits at the same time as you save money on taxes. You can do that by transferring some of the shares in your company to a holding company and then paying dividends to the Holdco.”

“What’s the point of doing that?” David asked.

“There are two reasons. First of all, by not taking the cash out of the company personally you can pay just the low rate of corporate tax. There is no tax on intercorporate dividends of this type. So the transaction occurs with no tax cost at all. Second, by shifting the cash and other assets to a holding company that’s not in the business of engineering, you’ll protect your savings from the engineering company’s creditors.”

“That sounds pretty good,” David said.

“It is good. And there’s a third major advantage. You can do all this while still allowing the engineering company shares to qualify for the small business capital gains exemption.”

“What is the capital gains exemption?”

“If you sell the shares of the company,” I explained, “the small business capital gains exemption allows you to avoid tax on the first $750,000 of capital gains. So if you sold your shares for, say, $1 million, you would pay capital gains tax on only $250,000, not on the entire sales amount. Using the exemption would save you taxes of $150,000.”

“We’re undergoing a pretty substantial period of growth right now,” David said. “I think my business is going to expand very rapidly in the future. The shares may be worth about $700,000 now, but in a couple of years they could be worth twice that amount. So getting a capital gains exemption when I sell my shares could be very beneficial to me.”

“The situation may be better than that,” I explained. “The exemption is not one per company. It’s one per shareholder. So if you were able to sell some shares to your wife or kids now, you might be able to obtain additional exemptions for the future. As a rule when anyone buys shares, they have to pay full market value. And that could be expensive for your family members. However, using the holding company structure that I’ve discussed with you, it is possible to create a situation where the common shares of the company are worth very little. We do that by shifting the value in the company to special shares owned by you or by the Holdco. Then your wife or a family trust for your kids could buy shares in the Opco at low cost. The increase in value of the company would be shared with them. If we did that, it’s possible that the family would pay little or no tax on the sale of the Opco shares.”

“Sounds good.” David said. “Where do we go from here?”

“I’ll do an analysis of your company and then develop a plan with the input of your lawyer. We’ll create a holding company structure that works for you and we’ll include other family members in the shareholder group. We can produce a program that lowers your tax today, increases your rate of savings and safeguards your assets from creditors. It’s ironic that this kind of work goes it two directions at the same time. It’s an essential part of planning for retirement, but it’s also something you should consider if you expect your business to be entering a growth phase.

Hank Bulmash, MBA, CA is a principal of Bulmash Cullemore, chartered accountants of Toronto. For more information, e-mail Hank at hank@businesslab.ca