How Small Business Owners Can Benefit From Differences Between Holding Company and Trust

An image of a small business owner discussing their holding company with their local accountant

Running a business is very different than doing a job. Your company pays corporate tax on business income, and you pay personal income tax on the dividend and salary you get from your business. Holding too much cash in your company may be tax-efficient, but you expose your earnings to business credit risk. Carrying a lot of money or asset in your personal account could protect your assets from business risk but will create a significant tax liability. If not your account and neither your company’s account, where can you store assets and cash tax efficiently while protecting them from creditors? Such complex problems need intelligent solutions like a holding company or a family trust.

While both segregate business assets from personal and business creditors and distribute income tax efficiently, they differ by nature and objective. Both pay taxes and have accounting needs, but they are helpful in different ways. This article will explore their differences and understand how small business owners can benefit from them.

What are a Holding Company and a Trust?

By definition, a holding company holds outstanding voting stocks of an operating company (which produces or sells goods or services) and gets all the benefits of a shareholder. Holding companies are generally called parent companies. The operating company can transfer dividends to the holding company through tax-free inter-corporate dividends.

Apart from shares, a holding company is a great tool to co-own real estate, investments, and other public companies’ shares. For instance, John and his five colleagues purchase a building to run a hospital. The six partners can create XYZ holding company to own the building and get shares of the holding company, making it easy to co-own assets. The XYZ Holding company can charge rent from the six partners, which could be shown as a business expense by the operating partners.

By definition, a trust is a company where the grantor transfers the assets, and the trustee manages these assets and distributes income from them to the trust’s beneficiaries. You can add your family members, like spouses and children, to the trust and give them dividends.

Protecting Assets from Individual Or Company Creditors

While you can defer tax by retaining income in the company, your retained income is exposed to business risk. A holding company is a separate legal entity, and its assets are free from the risk of the operating company.

For instance, John owns a building, collects rent and invests it in stocks and debt funds. He transfers excess cash and long-term investments in a holding company regularly. One day, there is a short circuit in the building, and John faces a significant penalty for the damage caused. All his business assets are exposed to the penalty. But his holding company investments remain unaffected.

Let’s take another scenario where John transfers the building to a family trust and admits his family members as trust beneficiaries. His wife falls into colossal debt, and her assets are ceased. But her creditors cannot use the building to claim debt as the building is the asset of the trust, safeguarding it from individual credit risk.

Both trust and holding companies protect assets from individual credit risk differently. If you want to credit-proof your surplus business earnings without allocating them to your family, you may transfer them to a holding company. A holding company helps you have more control over your assets, whereas you have limited control in a trust.

A holding company is better if you want higher decision-making power in managing your assets and income while credit-proofing them.

Tax Benefit of a Holding Company and a Trust

A trust has a better tax advantage than a holding company. In a holding company and trust, you can transfer the surplus business income tax-free and defer your personal income tax payments. You can also avail of the lifetime capital gains exemption in both cases.

For instance, John has $1.2 million in cash and investments retained in the business, and he now wants to sell his $3.5 million business for a $5 million capital gain. He need not pay any tax on up to $913,630 under the lifetime capital gains exemption (LCGE). But he won’t qualify for this exemption, as the Canada Revenue Agency (CRA) requires,

  • 90% of the company’s assets will be used in active business at the time of sale.
  • 50% of the company’s assets to be used in active business two years before the sale.
  • The business owner must have held the shares for at least 24 months before the date of the sale.

If John transfers the surplus earnings regularly to a holding company, he can make his operating business LCGE-ready and reduce his taxable capital gain. He might have to restructure the share to add family members to the holding company. But in the case of a family trust, John can multiply the $971,190 LCGE in 2023 by his trust beneficiaries. So if John has two members in his family trust, he can get a combined LCGE of $1,942,380. Note that the CRA keeps increasing this LCGE limit annually.

A family trust has a better income splitting and LCGE tax advantage over a holding company.

Both family trusts and holding companies have their benefits, and they may differ from case to case. You can have one or both, depending on your end objective. In estate planning, tax advisors might use family trusts to take advantage of the lower-marginal tax rates of family members to distribute more income and multiply LCGE. They may use a holding company to credit-proof the assets.

These business structures are complex, and changes in tax laws complicate things further. A professional tax advisor can design and maintain these structures while keeping your assets safe from creditors and higher taxation.

Contact Edelkoort Smethurst CPAs LLP in Burlington to Help You Set Up a Business Structure

Talk to a professional tax advisor to help set up a business structure that meets your business objective while protecting your wealth. At Edelkoort Smethurst CPAs LLP, our tax consultants and accountants can provide services such as preparing accounts of holding companies and trusts. To learn more about how Edelkoort Smethurst CPAs LLP can provide you with the best estate planning and business structure expertise, contact us online or by telephone at 905-517-2297.