Holding Companies – Issues to Consider

I have written several blog posts dealing with utilizing a holding company (“Holdco”) either directly as a parent company to your operating company (“Opco”) or indirectly as a beneficiary of a trust. These posts include:

Creditor Proofing Corporate Funds - This post discusses how a Holdco can protect surplus corporate funds and how for income tax purposes, the transfer of funds via a dividend from your Opco to the Holdco is in many cases tax-free (connected corporations).

Should Your Corporation’s Shareholder be a Family Trust instead of a Holding Company? - This blog examines some “fancier” tax planning to not only creditor proof funds, but allow for possible income splitting and multiplication of the capital gains exemption.

Corporate Small Business Owners: Beware; the Capital Gains Exemption is not a Gimme - This post explores the potential issues you may have in accessing the Capital Gains Exemption (“CGE”) including where your Holdco over time has accumulated too much cash and investment assets.

Because the concepts discussed in the blogs above are very complex (even for accountants), these posts have led to numerous questions by readers. In reading these questions, people are typically confused by the interaction of creditor proofing, income splitting and accessing the CGE, especially where they already have a Holdco in place with significant excess cash and/or investment assets. Thus, I thought today I would try and provide a bit of a road map for using a Holdco.

Working Backwards

Creditor Protection

The main reason small businesses owners typically consider using a Holdco in the first place is to creditor protect excess funds earned in their operating company. Most people find the concept of creditor protection (transferring cash and other assets from your Opco to remove the risk of someone suing Opco and making a claim on those assets) simple to grasp and in almost all cases; it makes business and income tax sense. Thus, I am assuming creditor protection is a given when considering using a Holdco.

Capital Gains Exemption

Where you do not think you can sell your business (the value of your business is just personal goodwill such as in a consulting business) a standard holding company often makes sense.

Where Holdco planning gets more complicated is when you want to ensure you have access to your CGE (while alive or when you pass away) and/or want to multiply the exemption and/or want to use your Holdco for income splitting purposes. The key concept to understand here is that; to access your CGE you or a family member must personally sell the shares of your Holdco (since you own the shares of your Holdco which in turn owns your Opco) and Holdco must meet various criteria to qualify for the CGE. If you have your Holdco sell the shares of your OPCO, there is no CGE, since it is a corporation selling, not an individual.

Situations Where you do not Currently have a Holdco in Place

If you currently own 100% of your Opco or own your Opco together with your spouse, you have a couple decisions to make before incorporating a Holdco.

Again, assuming creditor protection is a given, you need to determine if you think you will be able to access the CGE in the future. If the answer is no, you will probably be fine with a garden variety Holdco (Holdco owns 100% of Opco) especially if you already own Opco with your spouse.

Where you own Opco 100% personally and do not think you can access the CGE, you may want to give consideration to freezing (value of Opco is “frozen” at the current fair market value and you get special shares worth the frozen value) Opco and bringing your spouse in as a shareholder in Holdco. Again, in this situation, you would probably just use the typical Holdco/Opco structure with Holdco owning Opco 100%; however, you would have to concern yourself with ensuring you are not subject to punitive income tax rules, for which you would need income tax advice.

No Holdco in Place, but You may be able to Sell your Company in the Future to Access the CGE

Where you think your corporation is saleable to an arm’s length person in the future, the standard Holdco/Opco structure may not be appropriate, as damming cash in your Holdco may put your ability to claim the CGE in jeopardy.

In these cases, subject to your specific circumstances and only after consulting with your tax advisor, you may use either taxable dividends, stock dividends, an estate freeze or some kind of butterfly (a reorganization in which non-qualifying assets are transferred on a tax-free basis to a newly formed corporation, provided that no sale to an arm's length party of the shares of the small business corporation is contemplated at the time of the reorganization) to provide a structure that will allow Opco/Holdco to either constantly remain onside the criteria for the CGE or at least provide a mechanism to stay onside. Based on the recent Federal budget, your advisor may have to concern themselves with your company's safe income, in addition to the punitive rules I noted above.

As discussed in the “Should Your Corporation’s Shareholder be a Family Trust instead of a Holding Company?”, where you have children (especially teenage children or older), it will often make sense to “freeze” the current value of your operating company to you and/or your spouse (if they have original ownership in the Opco) and have a family trust (with a holding company as a beneficiary of the family trust) as the parent of Opco.

Excluding the cost of undertaking this transaction, this structure can provide for multiplication of the capital gains exemption, income splitting (many parents use this structure to tax effectively pay for University) and creditor protection. The nuance here is that the Holdco is not the parent of Opco, but a beneficiary of the trust and therefore is not an impediment to accessing the CGE in the future. Once again, there are punitive tax rules to be wary of and tax advice is essential.

What if I Have a Holdco already in Place?

In situations where you already have a Holdco in place with significant assets, your planning is very complicated and fact specific and beyond the scope of this post. However, typically, subject to your specific fact situation, your advisor will likely suggest either a butterfly, freeze transaction, payment of a taxable dividend or use of a stock dividend that will allow for potential access to the CGE in the future. In cases of a freeze, this may mean you will be required hold the shares at least two years to qualify for the CGE.

I have attempted in this post to provide a bit of a road map for using a Holdco or a variation of a Holdco. However, this topic is extremely complex and fact specific and as such, I have not even got into the various punitive income tax provisions such as the corporate attribution rules amongst the various other punitive rules.

Thus, I cannot stress enough, that this entire blog is simplified and that you should not even consider undertaking any kind of Holdco planning without receiving tax advice from your accountant or tax lawyer.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Cottage Trusts

Last week Katy Basi wrote a blog post on the various estate planning challenges in passing on your cottage to your family. Today, in part 2 of her series, Katy discusses the use of cottage trusts to facilitate the transfer of your cottage. I thank Katy for her excellent series.

Cottage Trusts

By Katy Basi

 

This blog is a follow-up to my previous blog on the topic of inheriting a cottage, cabin or chalet. There are three main reasons that I have come across for a cottage in Ontario to be owned by a trust:

1) Minimization of estate administration tax, aka probate tax. Ownership of a cottage by a trust was a popular strategy in Ontario in first half of the 1990’s as a way to avoid having to pay probate tax on the value of the cottage. (In the first half of the 1990’s the Ontario government increased the rate of probate tax from its then fairly negligible rate to its current level (1.5% of the fair market value of an estate over $50,000)). A number of cottage owners were convinced to transfer the cottage to a trust in order to avoid probate tax on the value of the cottage upon their death. Many of these trusts are now reaching their 21 year anniversary. Without professional planning, a cottage trust will be required to pay tax on any accrued capital gain on the cottage due to the “21 year deemed disposition rule”. Given the increase in Ontario cottage prices over the last 21 years, very significant tax bills could result. There is often planning that can be undertaken to avoid this capital gain, usually involving a transfer of the cottage to one or more beneficiaries of the trust, but this planning must be undertaken a number of months before the 21st anniversary. If this is your situation, do not delay in getting professional advice!

2) Protection from having to share the value of the cottage upon separation or divorce. As noted in my previous cottage blog, a cottage often qualifies as a matrimonial home for family law purposes, in which case the value of the cottage is shareable upon a separation or divorce (as part of a process called “equalization”). If the cottage is instead owned by a discretionary trust, with a number of beneficiaries, and no guaranteed right of the beneficiaries to any of the income or capital of the trust, the argument can be made that none of the beneficiaries actually own the cottage or have any right to the cottage that can be valued, so that no equalization payment should be made. I advise my clients that a family court may “look through” any trust, including a cottage trust, and allocate a value to a discretionary trust interest. However, if three siblings would otherwise co-own a cottage, each having a one-third interest subject to potential equalization, this situation may be ameliorated by having a discretionary family trust own the cottage with the three siblings as trustees, and the siblings and all of their children as potential beneficiaries. If each sibling has two children, there will be 9 beneficiaries. The value of a 1/9 interest in the trust will be far less than the value of a 1/3 direct ownership interest, and there is a chance that a sibling’s interest will be valued at nil due to the discretionary nature of the trust.

3) “Wait and see” trust. When a cottage owner wants to give their children the option of inheriting the cottage, but is unsure as to whether the children will be able to deal with the practical issues of cottage ownership, and the even greater challenges of cottage co-ownership, a “wait and see” trust may be a good option. The cottage owner leaves the cottage to a cottage trust in his or her Will. The cottage trust is structured to last for the length of time that the parent thinks will be required for the children to figure out a workable long term plan for the cottage. If there are sufficient funds in the estate, the parent may leave a “cottage maintenance fund” as part of the cottage trust in order to reduce the financial burden on the children of maintaining the cottage for the duration of the trust. Upon the termination of the cottage trust, the children figure out if they will co-own the cottage, whether one child will buy out the other children’s interests, or whether the cottage will be sold to a third party.

Transferring a cottage to a trust during the lifetime of the owner can trigger capital gains tax, unless the trust qualifies as an alter ego trust or a joint partner trust. In addition, the trust itself is a separate taxpayer which pays tax at the highest marginal rate, resulting in higher tax bills, under certain circumstances, compared to ownership by the previous owner. Cottage trusts are often created in the Will of the cottage owner as a method of assisting the beneficiaries to keep the cottage in the family, given that any accrued capital gain on the cottage is taxable upon the death of the owner in any event (especially where the owner does not leave the cottage to his or her spouse). Cottage trusts are not appropriate for all situations, but they can be a lifesaver under the right circumstances.

Katy Basi is a barrister and solicitor with her own practice, focusing on wills, trusts, estate planning, estate administration and income tax law. Katy practiced income tax law for many years with a large Toronto law firm, and therefore considers the income tax and probate tax implications of her clients' decisions. Please feel free to contact her directly at (905) 237-9299, or by email at katy@katybasi.com. More articles by Katy can be found at her website, katybasi.com.

The above blog post is for general information purposes only and does not constitute legal or other professional advice or an opinion of any kind. Readers are advised to seek specific legal advice regarding any specific legal issues.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Introducing a Family Trust as a Shareholder in a Private Corporation

Two weeks ago I discussed using a holding company as a simple method to creditor proof excess corporate funds or other assets in a private corporation. In this blog I will discuss a “fancier” and far more complex transaction that can not only achieve creditor proofing, but potentially provides a means to income split with family members, potentially provides multiple access to the $750,000 capital gains exemption and finally, may provide a means to crystallize or "freeze" the income tax liability related to your company's shares at death.

For the purpose of this blog, I will  use the example of Starlet Yohansen who owns all the common shares of Movie Star Limited ("MSL"). The shares initially cost Starlet $1 and are now worth $3,000,000.

For Starlet to concurrently achieve all the objectives noted above, she would typically “freeze” the value of her  common shares in MSL. At the date of the “freeze”, Starlet would exchange her common shares for special preferred shares with a value equal to the value of the common shares exchanged, that being $3,000,000. Thus, at this point in time, there are no common shares and Starlet owns special shares worth $3,000,000. These special shares cannot increase in value, hence the term "freeze".

Any future growth in the value of MSL over the current value of $3,000,000 will accrue only to the new common shares that are issued as part of this reorganization. That growth will accrue directly, or indirectly through a family trust, to potentially Starlet's family members and/or a Holding company by having them subscribe for the new common shares issued in MSL (Starlet can also maintain some of the future growth if she subscribes for the new common shares or is included in the family trust). Often we see this strategy being used in succession planning when the owner-manager wishes to transfer ownership of their operating company to the next generation, but this strategy can be used without succession being the objective.

The beauty of the freeze is that Starlet's maximum income tax liability on her MSL shares has been established (unless she subscribes for more common shares). At Starlet's death, her income tax liability on her MSL shares will be equal to $3,000,000 times the applicable income tax rate at that time, likely around 23%. As Starlet knows the maximum income tax liability on her special shares she can plan to pay this liability by putting aside funds or by purchasing life insurance.

In addition, we often further reduce Starlet's  income tax liability by redeeming her frozen shares over time, which typically creates a current taxable dividend to Starlet, but also serves to reduce the value of the frozen shares by essentially the value of the dividend reported [ie: if Starlet redeems 500,000 shares that have a paid up capital and adjusted cost base of $1, she will have a deemed dividend of approximately $500,000 to report on her personal income tax return and her special shares are now only worth $2,500,000 ($3,000,000-$500,000 redeemed)]. Thus, if Starlet lives long enough, much if not all of her income tax liability can be eliminated prior to her death by redeeming her shares slowly over time.

If Starlet uses the Yohansen Family Trust to subscribe for the new common shares of MSL, the beneficiaries of the family trust would typically include Starlet, her spouse (although given Starlet's past history, we may want to leave her spouse out of the trust), her children and a Holding company. The inclusion of these beneficiaries can provide tax-effective income splitting on dividends received from MSL when the children are 18 years of age or older or when a spouse is in a lower income tax bracket (Starlet may have a trophy husband who does not have much income). The trust can also provide tax-effective income splitting on the sale of a business irregardless of the beneficiary’s age.

Generally, a family trust is discretionary. The trustees can tax effectively allocate the income received by the trust (i.e. dividends from MSL) to any or all of the beneficiaries including Starlet, so long as they are 18 years of age or older. A beneficiary who is 18 years of age or older and has no other sources of income can receive up to $37,500 in dividends tax-free. This strategy is a great way to help fund a child’s post-secondary school education (in addition to an RESP) or other expenses, while also lessening the family’s overall income tax liability.

If the shares of MSL are sold in the future, any sale proceeds in excess of the value of Starlet's original  frozen special preferred shares ($3,000,000 maximum) can be allocated to the beneficiaries of the trust. This may permit the utilization of the $750,000 capital gains exemption by each of these beneficiaries. A word to the wise though, any sales proceeds allocated to a beneficiary of the trust, including a minor child, will result in the money legally belonging to the child.

Finally, back to the original creditor proofing issue. The inclusion of a Holdco as a beneficiary of the trust would provide a means to transfer any excess funds in MSL as a tax-free via a dividend from MSL to Holdco thus creditor proofing the excess cash in MSL by moving it to Holdco.

I am sure there are very few readers still awake or with eyes not glazed over; but believe it or not, this type of reorganization has been simplified greatly for discussion purposes. There are several pitfalls along the way and in the future that must be avoided in order to successfully achieve the objectives noted at the beginning of this blog. If you are contemplating undertaking such a transaction, you must consult your accountant and lawyer to ensure that the transaction makes sense given your personal situation and that no details are missed in carrying out the finer points of the reorganization.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the material is time sensitive and subject to changes in legislation or law.