Good Structure for Early Stage Companies
A common structure for businesses is to have the operating company (“Opco”) owned by a holding company (“Holdco”). One primary reason for this is to be able to remove excess cash from Opco without paying tax, via inter-company, tax-free dividends. The funds can then be invested by Holdco after having only paid a relatively low corporate tax rate at the Opco level. Although this is a good option, I usually propose a better one to my clients which involves the use of a discretionary family trust (the “Trust”). This alternative option still allows them to achieve the aforesaid result, but it has enormous additional benefits such as enabling the use (and, indeed, the potential multiplication) of the lifetime capital gains exemption (the “LCGE”) on a future sale of the business, as well as protecting the assets from personal creditors of the individual or individuals who would have otherwise been the direct shareholders of Opco if the Trust wasn’t utilized.
What is the Alternative Structure?
So what does this structure look like? Simple. Instead of Holdco owning Opco directly, the Trust owns Opco. Holdco would also be set up and be utilized. However, it would not hold the shares of Opco directly. Rather, it would be a beneficiary of the Trust. This structure allows dividends to still be paid up and parked in Holdco via dividends to the Trust (which owns Opco) which are then flowed out to Holdco (which, as aforesaid, is a beneficiary of the Trust). In this scenario, Holdco would still be considered “connected” (within the meaning of subsection 186(4) of the Income Tax Act (Canada)) with Opco, thus enabling it to receive tax-free dividends (assuming certain other conditions are met). No tax is realized by the Trust since it elects to allocate the dividend income to Holdco as the beneficiary.
Use of the Lifetime Capital Gains Exemption
There is a severe limitation in the Holdco-owns-Opco structure if you wish to retain the possibility of selling your business in the future. Since one of the purposes of this structure is to remove excess cash from Opco and park it in Holdco and then invest it in Holdco (or simply to remove it from Opco to protect it from Creditors of Opco), you will end up with too many passive assets in your structure which do not relate to your active business operations carried on by Opco. This will most likely render you ineligible for the LCGE because you would need to sell the shares of Holdco in order to potentially qualify for the LCGE, but Holdco will contain too many passive assets to qualify. However, if the Trust owns the shares of Opco, the Trust would sell the shares of Opco which had been kept “pure” of excess passive assets. The resulting capital gain on a sale of Opco to a third party purchaser can be allocated to any one or more of the beneficiaries of the Trust who can then use their LCGEs to the extent they have not previously used up their limit. Although the same methodology of moving excess cash up to Holdco, Holdco wouldn’t be in the direct chain of companies being sold and, therefore, would not impact the eligibility of Opco’s shares for the LCGE.
How Many Lifetime Capital Gains Exemptions Can be Used?
There is NO LIMIT to the number of beneficiaries who can use their LCGE. In 2021 I set up a structure for a family to be able to utilize 5 exemptions. 3 years later they have a signed LOI and will be sheltering close to $5 million of proceeds of the sale from capital gains tax. That is about one and a quarter million dollars of tax savings. I have even heard of a case where as many as 15 beneficiaries of a trust all utilized their LCGEs from a sale.
Creditor Protection
I will elaborate on this more in a future blog post; however, suffice it to say for now that putting your assets in a discretionary family trust keeps those assets out of your own hands directly (although you can still control and have access to those assets). This protects the asset against any of your future creditors (you never know what could happen in life). In the case of Opco, the value of the entire enterprise can be kept technically out of your hands and can therefore be shielded against your creditors. The same trust utilized in this structure can also hold any other assets/investments of yours. Proper structuring of this is essential and will be elaborated upon in the future.
Just for Fun
Just for fun, here is a (redacted) email I recently sent to a client summarizing very briefly these concepts that I had just explained to them in a video meeting. This case involved two arm’s length shareholders, so there are some other nuances you might pick up on.
“Hey [Shareholder 1] and [Shareholder 2],
Nice to meet you earlier today.
Here is a very brief summary of the three options we discussed:
Option 1 – Do Nothing
Leave structure as the status quo. Dividends paid out to you as the owner/managers are subject to personal tax at your respective tax rates.
Pros: No work needed, no cost.
Cons: less flexibility on taking funds out in each shareholder’s respective discretion and therefore less flexibility on when to pay personal tax on such funds.
Option 2 – Holding Company Structure (No Trust)
Each shareholder sets up a holding corporation (“Holdco”) to hold their shares of [Opco].
Dividends can be paid up to each respective Holdco without realizing any tax consequence (as such dividends will be to “connected companies” within the meaning of 186(4) of the income tax act). Each individual can then choose to remove funds from their respective Holdco in their own discretion. Each individual can decide to leave excess funds in their Holdco (thus paying no tax at this stage beyond the initial low rate of corporate tax paid by [Opco] on the business income) which they can use to invest. As mentioned in the meeting when [Shareholder 2] stepped away briefly, if one’s holding company then realizes a capital gain in the future (such as, for example, on a sale of investment real estate that would have been acquired in Holdco), such Holdco would obtain a capital dividend account balance equal to half of the capital gain which essentially means an amount that the individual can remove from the company on a tax-free basis via paying a “capital” dividend.
Pros:
Relatively small reorganization, only one additional entity each.
Tax deferral benefits.
Flexibility as among shareholders to deal with their profits how they want to without affecting the other shareholder.
Can protect assets not needed by [Opco] from potential creditors of [Opco].
Cons:
This structure would likely eliminate the ability to utilize (or at least fully utilize) the lifetime capital gains exemption in the future, as excess cash and other passive investments would likely build up in Holdco thus rendering it offside for capital gains exemption eligibility.
The initial cost to implement this structure, plus the additional annual compliance required for the holding corporation (i.e., extra accounting fees) (albeit somewhat minimal)
Option 3 – Trust Structure with Holding Company
Each shareholder would own their shares of [Opco] through a trust. A holding company would be set up for each shareholder which would serve as a corporate beneficiary of the trust.
One additional company would be required for each shareholder for purely technical reasons (as explained in the meeting) – namely, such companies would exist merely to ensure that the companies are “connected” with each other to ensure inter corporate dividends are not taxed.
So the exact structure is that one trust for each of the individuals owns a holding company which in turn holds the shares of [Opco]. Each trust also has another corporation as a beneficiary of the trust.
Pros: This structure has all the benefits of option 2, except that it would not only preserve the potential to utilize the lifetime capital gains exemption but each individual can potentially multiply the capital gains exemption by having numerous beneficiaries of their trust who can each utilize their own capital gains exemptions in their capacities as beneficiaries of the trust.
Cons:
The initial cost to set up
The additional annual maintenance/tax return for 2 additional companies and the trust for each of you.
On a side note, I meant to mention to you guys, that if you don’t have a shareholders’ agreement in place, I highly recommend one which would include things like a “shotgun clause”, provisions relating to what happens to a shareholders’ shares if he/she dies, loses capacity, gets divorced, etc., what happens if an offer to purchase comes along – i.e., tag-along/drag-along rights, and numerous other important clauses. This would be recommended regardless of which option above you choose. Happy to answer any questions you have about this as well.
Let me know if you have any further questions at any time.
Thx very much.
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