As your small business grows, your legal structure will need to evolve to keep up. At some point, you may probably decide to incorporate your business and own the shares of your corporation directly. The next logical step to consider is the possibility of adding a holding corporation to act as the owner of the active business while you own the shares of the holding corporation. There are two key advantages to this structure: asset protection and tax deferral.
Holding corporations do more than simply hold shares of an active business. In a typical structure, ownership of the business’s most valuable assets are legally transferred to the holding corporation. Then, the holding corporation rents, leases or sells them to the operating corporation. From a practical viewpoint, nothing changes. However, normally, the operating company is more at risk of lawsuits or bankruptcy. If something happens with this structure in place, the assets are protected because they do not belong to the company being sued or going bankrupt. In many cases, after an unfortunate event, a new operating company can be set up quickly.
A variation of this structure is used when the operating company is profitable and has a lot of cash on hand. If done properly, the operating company can pay a tax-free dividend to the holding corporation, which then takes the funds and lends them back to the operating company. The loan is secured by a first ranking lien and, in a way, you become your own preferred creditor.
These forms of creditor proofing a company are complex and have tax and legal implications. Consult a professional before undertaking a reorganization.
Used correctly, a holding corporation can also be used to defer taxes. In an ideal scenario, the operating company is making profits that it can distribute to its shareholders. You, as shareholder, do not need or want to take this money personally, because you would pay high taxes on a salary or personal dividend. You would rather leave them in the company, since it pays a lower tax rate but are afraid that you will lose the lower tax rate if you leave too much profit in the operating company.
This is where you can use a holding corporation to defer the taxes on money taken out of an operating corporation. If done right, the operating company can pay the holding corporation a tax-free dividend. In this way, the operating company pays a low rate of taxes on its operating income, and the tax payable by the shareholder is deferred until a dividend is paid. The holding corporation will pay a higher rate of taxes on its investments than the operating company, but that can be managed by choosing tax-effective investments.
Here again, there are many important factors to consider, and you should consult a tax advisor prior to implementing this strategy.