A holding corporation shelters surplus from the risks of the active business and lets each partner set their own pace of withdrawal. It creates no tax saving by itself, and above all: holding your shares through a holding corporation can cost you the capital gains deduction on a sale. That can be prevented, provided you think about it while building the structure. Constitution from $549 at Labo Legal.
The holding corporation is the structure most talked about and least explained. Many entrepreneurs are sold one as a tax-saving tool, then discover it is nothing of the kind. Here is what it actually does, and at what point it is worth what it costs.
What it is, in one sentence
A holding corporation is a business corporation whose activity is not to operate a business but to hold: the shares of your operating corporation, investments, sometimes real estate. You hold the holding corporation, and the holding corporation holds the operating one.
Legally there is nothing exotic about it: it is an ordinary business corporation, constituted in the same way as the one described in our article on when to incorporate. What sets it apart is its place in the structure, not its nature.
Its three real uses
Sheltering the surplus. This is the first and the most concrete. Your operating corporation carries the risks: a client who sues, an unpaid supplier, an accident, a tax debt. As long as your accumulated profits sit in that corporation, they are within reach of its creditors. Paid up to the holding corporation, they stop being so. The usual mechanism is the inter-corporate dividend, whose tax treatment is worked out with your accountant.
Letting each shareholder set their own pace. Two equal partners do not have the same needs: one has a home loan to pay down and wants money out, the other would rather leave it all to grow. If each holds their interest through their own holding corporation, the operating corporation pays each of them and each then decides, alone, what to take. That defuses a permanent source of tension between partners.
Keeping your shares qualified. The capital gains deduction, described in our article on the tax advantages of incorporating, requires the corporation to meet conditions on the nature of its assets. An operating corporation that accumulates cash and investments eventually stops meeting them. Moving the surplus out to the holding corporation regularly keeps the operating one in a condition suited to a sale.
The trap no one mentions: the deduction
This is the most important point in the whole article, and the one that costs the most when discovered at the moment of sale.
The lifetime capital gains exemption, often called the capital gains deduction, is available to particuliers. A corporation cannot claim it. Now, if your shares in the operating corporation belong to your holding corporation, it is the holding corporation that realizes the gain on the day of the sale. The gain is indeed realized, but it is realized by a legal person, and the deduction does not apply.
The scenario is always the same. An entrepreneur sets up a holding corporation to protect the surplus, which is an excellent idea. No one explains the effect on a future sale. Five years later a buyer appears, and it turns out the structure has cost access to a deduction that would have sheltered a considerable part of the proceeds.
That does not mean giving up on the holding corporation. It means the question of a future sale has to be asked when the structure is being built, not when it is being sold. The solutions exist, they are well known, and they are put in place in calm conditions.
The ways to do this properly
Four approaches come up, often combined. They belong to tax planning and are decided with your accountant or tax adviser; our role is to build and document the structure chosen.
Holding some of the shares personally. The simplest configuration has you keep in your own name part of the participating shares of the operating corporation, while the holding corporation holds another part, or holds shares meant to receive the dividends. You keep personal access to the deduction on the portion you hold, while still using the holding corporation to move surplus out.
Crystallizing the exemption. Where the value of the business has already grown and the shares are then to be transferred to a holding corporation, it is possible to realize a gain deliberately, up to the deduction available, before the transfer, so as to use it now rather than lose it. The operation is planned, documented and requires a valuation.
Purifying the operating corporation. The deduction requires the corporation to meet conditions on the nature of its assets and on a holding period. An operating corporation that accumulates cash, investments or real estate eventually stops meeting them. Moving those assets out to the holding corporation regularly is precisely what keeps the operating one qualified, which makes the holding corporation an ally rather than an obstacle, provided the shareholding is well structured.
Interposing a trust. This is the most powerful approach where the family situation lends itself to it, and it deserves a section of its own.
The trust, where the restructuring allows for it
A discretionary family trust can hold the shares of the operating corporation, with the family members as beneficiaries and, often, the holding corporation itself.
The main advantage, for our purposes, is this: the gain realized on a sale can, depending on the terms of the deed and the applicable rules, be attributed to beneficiaries who are individuals. Each can then, if eligible, claim their own deduction. A family can therefore multiply access to the deduction rather than concentrating it on one person. Add to that real flexibility in paying dividends and in eventually passing the business to the next generation.
It is not a tool for everyone. A trust costs money to set up and to maintain, it requires returns of its own, it presupposes trustees who take real decisions, and the rules on split income now limit some of the uses once made of it. There are also deemed disposition rules that force you to think of a trust over a long horizon. In other words: an excellent vehicle for a business that has value and an owner who has a family, an expensive gadget for a one-shareholder service company.
The natural moment to consider one is during a reorganization, when the articles are already open and the share classes are being redistributed. Grafting it on afterward costs more.
The rollover requires a defensible valuation
As soon as shares are transferred to a holding corporation or a trust, you are not merely moving a piece of paper. There is a disposition, and therefore a potential gain to be realized immediately, unless you use the rollover mechanism that defers the tax in exchange for consideration that includes shares.
That mechanism rests entirely on one figure: the fair market value of the shares transferred. It determines the agreed amount in the tax election, the value of the shares issued as consideration and the balance of the whole operation. A value picked at random, or set to reach a convenient result, is exactly what an audit will challenge.
Three precautions follow. Have a évaluation proportionate to what is at stake: for a small service company, a documented and consistent method may be enough; once the amounts become significant, a professional valuation is a reasonable investment. Provide for a price adjustment clause in the documents, so the value can be corrected if the tax authority challenges it, rather than leaving an unintended taxable gain. And observe the form and the time limits of the tax election, which cannot simply be backdated at will.
This is the part of the operation where law and tax meet: the tax adviser establishes the value and the strategy, the lawyer drafts the transfer agreement, the resolutions and the articles that carry it. Doing one without the other is the recipe for a file that will have to be redone.
Holding directly or through a holding corporation
| Direct ownership | Through a holding corporation | |
|---|---|---|
| Accumulated surpluses | In the corporation that carries the risks | Separated from the risky activity |
| Taking money out | A dividend taxable in your hands | Each shareholder chooses their own pace |
| Eligibility for the exemption | Degrades as surplus accumulates | Easier to preserve |
| Entities to maintain | One | Two |
| Annual cost | One corporation’s filings and bookkeeping | Of two corporations |
| Complexité | Faible | Moderate, with flows of money to document |
The right question is not “do I need a holding corporation” but “what would it solve in my situation”.
Building the structure from the start, rather than rebuilding it
Everything above describes adding a holding corporation to a business already running, with the transfers and valuations that entails. There is one situation where all of that can be avoided: building it properly on day one.
This is particularly true where several partners start out together. Rather than each holding their shares of the operating corporation in their own name, each sets up their own holding corporation, and it is the holding corporations that hold the operating one. The configuration is put in place at constitution, with no transfer of shares, no rollover, no valuation, and therefore none of the cost or the risk those operations carry.
What it solves comes down to one word: friction. One partner needs $90,000 out this year to pay down a home loan, another wants everything left to grow. One partner wants a salary in order to contribute to the pension plan, another prefers dividends. Without holding corporations, every payment out of the operating corporation touches everyone at once, and the discussion comes back every year. With one holding corporation each, the operating corporation pays the holding corporations and each partner then decides, alone and without having to persuade anyone, what to take and when.
The trade-off is real: as many corporations to maintain as there are partners, plus the operating one. It is justified only if the amounts at stake exceed the cost of upkeep. But where that is so, doing it at the outset costs a fraction of what the same structure will cost three years later. And the shareholder agreement will then have to be drafted on the footing that the shareholders are corporations, not people: the clauses on departure, death and disability must reach the individuals behind the holding corporations, failing which they never trigger at all.
Taking money out to fund another venture
Here is a scenario we see very often, and it illustrates well what the structure makes possible.
An entrepreneur has an operating corporation building up surplus, and wants to launch a second venture: a building, a shop, a stake in someone else’s business. If the money is taken out personally to invest it, personal tax is paid on the withdrawal and what is left gets invested. On a substantial sum the bite is considerable, and it comes before the new venture has generated a single dollar.
The holding corporation changes the order of things. The operating corporation pays its surplus up to the holding corporation, in a form whose treatment is planned with your accountant. The holding corporation then invests those sums in the new corporation, by subscribing for its shares or by lending to it. You are therefore investing dollars that have borne only corporate tax, rather than dollars cut down by your personal marginal rate.
Three honest qualifications. Personal tax is not erased, it is deferred to the day you take the money out for yourself. The treatment of sums moving between corporations follows precise rules and is planned before the transfers, not after. And a holding corporation that holds several businesses becomes an asset to protect in its own right, which is a reminder of why the risky operating business is kept separate from the rest.
This is also the moment to check the effect on each corporation’s eligibility for the deduction, and to update your ultimate beneficiaries in the register, since the chain of ownership has just changed.
What it does not do
Three expectations come up, and all three are wrong.
It saves no tax by its mere existence. Money that comes out ends up taxed in your hands, holding corporation or not. What it changes is the timing and the flexibility, not the principle. Anyone presenting it as an automatic saving is selling something good, badly.
It does not protect you from your own faults. The separation holds for the commercial debts of the operating business. A fault you commit personally, a suretyship you sign, an unremitted source deduction: none of that stops at the holding corporation’s door. Our article on director liability sets out those gaps.
It does not guarantee access to the deduction. On the contrary, badly structured, it costs you that access, as explained above. That is why a holding corporation is never put in place without the question of a future sale having been asked.
It does not shelter surplus retroactively. Moving cash out once a claim is already known or foreseeable exposes the operation to challenge. The protection is built in peacetime, through regular payments, not in a hurry.
From what point it pays
A second corporation means a second file at the register, a second annual declaration, a second set of books and higher professional fees every year. That cost is fixed; the benefit depends on what you accumulate.
Three signs that the moment has come. You regularly leave in the business sums you do not need to live on. Your activity carries a real risk of a claim, through the nature of the work, the presence of employees or the level of debt. Or you contemplate selling one day, and you want your shares to stay eligible for the deduction.
If none of the three applies, a holding corporation is probably just another cost. The calculation is done with your accountant, figures in hand; our role is to build the structure once the decision is made, and to document it properly.
The mistakes made in setting it up
Two recur. The first is creating the holding corporation and never moving any money: the structure exists on paper, the surplus stays in the operating corporation, and you pay for two corporations and get none of the benefits. The second is moving the money without documenting it: transfers between the two entities, with no resolution and no justification, create exactly the murkiness no one needs on an audit.
A holding corporation lives by its resolutions and by a minute book kept for both entities. That is the part the accountant does not do and that no one remembers to assign to anyone.
Frequently asked questions
Does a holding corporation save tax?
Not by its mere existence. Money that comes out ends up taxed in your hands, holding corporation or not. What it changes is when the tax falls and how much room you have, not the principle.
Can a holding corporation cost me the capital gains deduction?
Yes, and it is the most expensive trap. The deduction is available to individuals, not to corporations. If the holding corporation holds the shares of the operating one, it is the holding corporation that realizes the gain on a sale. That is prevented by holding some of the shares personally, by crystallizing the deduction, or by interposing a trust.
At what point does a holding corporation start to pay for itself?
When at least one of these three is present: you regularly leave sums in the business you do not need, your activity carries a real risk of a claim, or you contemplate selling and want to keep your shares qualified.