The Right Structure at the Right Time
Sabrina is a senior manager at PricewaterhouseCoopers LLP (PwC) and is the leader of the Private Company Services – Integrated Solutions group. She specializes in tax, working with owner managers on effective tax planning including structuring, estate and succession planning.
There are many benefits to private business owners resulting from having a holding company (Holdco) in their corporate structure. However, it is vital that placement of the holding company, and the ownership of shares in operating companies (Opco) is done strategically in the corporate structure to maximize all of the tax planning and wealth enhancement and protection benefits possible from having a Holdco.
In our experience, the traditional Holdco owning shares of Opco is often not the optimal choice of structure for businesses where there is or will be a future possibility to sell Opco shares as a Qualifying Small Business Corporation (QSBC).
Put another way, whenever we see corporate structures where a holding company owns the common shares of a potential QSBC, we believe there are often substantial opportunities for better structuring, with more benefit to the business owner. In this context it is vital to remember that only individuals have a $750,000 personal capital gains exemption (CGE); there is no such exemption available for companies.
One of the tax benefits of incorporation is the significant tax deferral provided by the low corporate tax rates, say 16% applied to active income earned by Opco. As compared to a top personal tax rate of say 46%, for a company earning $500,000 of net income per year the tax deferral available annually is $147,500. This is a staggering tax difference savings!
But to take maximum advantage of this deferral, funds have to be retained at the corporate level. If these funds are retained in the Opco, one creates a risk of putting the company offside the QSBC test. The accumulation of excess funds is not typically considered to be a business asset for purposes of the QSBC test, and therefore will disqualify the Opco as a QSBC. The implication of this would be that the shares would not qualify for personal $750,000 CGE on sale (or death). Avoiding this outcome is one of the primary reasons to have a holding company, so that Opco can be purified by means of ongoing dividends to Holdco.
Where Holdco owns the shares of Opco, and receives the dividend, while the QSBC purification of Opco might theoretically be accomplished, in reality the effort would be ineffective for CGE purposes. This is because Holdco owns the Opco shares and is not eligible for CGE. Only individuals are eligible for CGE. Thus, the existence of Holdco as the parent of Opco in the typical “in-line” structure usually prevents the business owner from ever realizing on his personal capital gain exemption as regards the accrued gains in Opco shares.
Better alternatives exist for placement of Holdco in the corporate structure, so that ongoing purification dividends can occur on a tax-free basis between corporations, and/or so that creditor-proofing dividends can similarly occur, all the while retaining ownership of the Opco shares in a way that individuals will be able to use their CGE if a buyer is found for the Opco shares while it qualifies as a QSBC. Such alternatives require the insertion of a family trust into the structure, which then directly owns common shares of Opco, and perhaps Holdco.
Not only is it important to have the proper structure in place in order to maximize tax, and preserve wealth, it is equally important that this structure be created at the proper time in the life cycle of the business. Far too many business people have found out this unfortunate truth at the wrong time.
What is the “wrong time”? The wrong time to be thinking about restructuring is when there is “contemplation” of a sale of Opco shares to an unrelated party!
To put some exceedingly complex rules into layman’s language, the Income Tax Act imposes very stringent rules on what can be done in terms of tax-deferred reorganization, when such actions can reasonably be considered to be done in “contemplation of sale” to an unrelated party.
In practice what this means is that you have to have your structure right, well in advance of any potential sale activity such that the restructuring activities cannot be considered to part of the same “series of transactions” as the ultimate sale. If the structure is wrong, and a sale opportunity presents itself, it is usually too late to do any tax-efficient restructuring to facilitate the sale because the stringent “in contemplation” rules have been activated. Thus at the exact time you need to have a great structure (at the time of sale), it is typically impossible to create that structure tax effectively if it was not previously in place.
Let us describe is an all-too common experience;
“Dave and Marie”, a married couple who have spent their careers creating a successful business “Opco”, had received previous advice to create Holdco to own the common shares of Opco. Dave and Marie each own 50% of the shares of Holdco, which owns all the shares of Opco. This structure was created to allow for ongoing purification of Opco for purposes of the QSBC test, and also just as prudent business practice to facilitate removal of excess assets out of Opco.
Opco has successful over the years and they used the structure as it was intended and now Holdco has $7 million of marketable securities, as well as ownership of Opco shares with a market value that they guess might be on the order of $5 million.
Dave and Marie are very excited when they come to see us as their new tax advisor, as they have just received an unsolicited offer from a company competitor to buy opco at $10 million. The company has even offered to complete the purchase as a purchase of shares (rather than assets), knowing that the after-tax result to Dave and Marie would be substantially enhanced by the $750,000 CGE that each of them could claim. Dave and Marie are fully intending to take this sale offer, utilize each of their personal CGE to partially shelter from tax.
Imagine their disappointment when we tell them that they don’t have any shares to sell that qualify for CGE, since they personally don’t own the Opco shares, Holdco does. The only shares they personally own are Holdco shares, and those shares don’t qualify because Holdco has too much value in marketable securities.
What is the moral of this story? It’s really very simple. Having the right structure at the right time provides the flexibility required to handle a variety of exit strategies well in advance of the actual exit.
If one avoids the “in-line Holdco” structure, with proper planning at the proper time involving use of a family trust all of the benefits of having a holding company in terms of QSBC purification and asset protection will be available, plus the opportunity for multiplication of the CGE is created with family members and/or tax-deferred rollovers of the family business shares to the next generation. Such structuring can also provide protection from the potentially disastrous tax consequences of an untimely death, and provide unparalleled flexibility in income splitting and estate and succession planning.
Some say “timing is everything in life”. This is perfectly true when it comes to creating the proper business structure!