Using personal holding companies

Still, many clients continue to own these personal holding companies and may have questions about them. In fact, there may be circumstances in which it would be better to avoid their use. These structures can, for instance, carry additional levels of complexity and costs; are a separate legal entity, requiring financial statements and separate corporate tax return; and, as with individuals, the corporation is taxable every year, with interest fully taxable and capital gains taxable at a 50% inclusion rate. In addition, investments held within corporations do not receive the dividend tax credit available to individuals and are fully taxable.

On the other hand, personal holding companies typically pay out their income to owners in the form of a dividend, which, at this level, is eligible for the dividend tax credit. Holding-company owners can control the timing of these dividends and may choose to take them every year or defer them. Various tax credits ensure that there is no double taxation on investment income as a result of taxes already paid on annual income at the holding-company level.

But it is common for business owners to set up a separate personal holding company to shelter investment assets that are not needed in an operating company’s business. The operating company may transfer profits to the holding company on a tax-deferred basis, and the holding company may then invest in securities. The original profits are not taxable until they are taken out of the holding company, but any income on the investments is taxable every year.

This tax-planning strategy is the reason for the continued existence of many holding companies, and often these companies continue to live on after the operating business is sold. Sometimes, the proceeds from the sale of business assets of the operating company will be kept within the holding company to defer taxes on a windup or distribution and then be used to purchase investment securities.

@page_break@ “Timing of income can be important from a tax planning point of view,” says Lisa Pflieger, department leader of financial planning for Edward Jones in Mississauga, Ont. “Income-tested benefits such as old-age security can be clawed back at certain income levels, and a holding company can allow a client to control the timing on the receipt of income from a business.”

Beyond addressing the needs of business owners, the main benefits of setting up a holding company are related to estate planning and income-splitting. To split income among various family members, assets can be transferred to a holding company, then a spouse or adult children can hold shares in the holding company. Dividends are paid to these family members and taxed in their hands. However, the income attribution rules that apply to any income-splitting strategies state that dividends paid to minors from a holding company are taxable at the highest rate – a.k.a. the “kiddie tax” – and the parent is jointly liable for the taxes.

And if your client has extensive and varied investment assets, instead of assigning assets to heirs, who then would have to register those assets in their own name upon inheritance, all of your client’s assets can be lumped into a single holding company and the heirs be made equal shareholders. Eventually, the heirs can split the assets by way of a corporate reorganization or by winding up the holding company.

Holding companies can also be useful when planning an estate freeze, which minimizes taxes upon death by transferring future growth of appreciating assets, but not control of these assets, to the next generation. At a chosen point during your client’s lifetime, investment assets are transferred to the holding company on a tax-deferred basis, with the owner taking back voting preferred shares that reflect the value of the assets and giving the heirs common shares that originally have no value. Properly structured, all future growth goes to increase the value of the heirs’ common shares, but voting control stays with the original owner’s preferred shares. Upon the owner’s death, the estate’s tax liability will be based not on current value of the investment assets but on their value at the time of their transfer to the holding company, minus their original cost base.

There may be other non-tax benefits to using a holding company, says Waters, such as limited liability protection, creditor protection, confidentiality or the indefinite life of a corporation. But one of the key disadvantages is that any losses realized within a corporate structure may be used only to offset other income earned within the same corporation. Alternatively, when your client owns investments personally, he or she can apply losses on these holdings against other sources of income and capital gains.

“Holding companies introduce a level of complexity,” says Pflieger, “and it’s important that clients work with a tax expert to fully understand the potential implications and tax consequences.”

© 2012 Investment Executive. All rights reserved.