As your small business grows, you will need to think about the best legal structure to support your long-term goals. To begin with, you may decide to incorporate your business. The main advantage of incorporating is to protect you from personal liability for any debts that your company owes. The next logical step is to add a holding company to own your business while you own the shares of the holding company. There are a number of potential advantages to this structure, which are mostly related to risk management and tax deferral.
TL;DR (Too Long; Didn't Read)
A holding company does not engage in operations itself, but it owns shares of other companies and thus influences or controls them.
What Is a Holding Company?
A holding company is essentially a corporation that holds the assets of another corporation. The held company is an operating company that sells goods or performs services and deals with members of the public. The holding company, by contrast, does not produce any goods or services and does not deal with anyone. It just operates as the bank and administration for the operating company. The term "holding company" comes from the fact that the entity has one job: to hold the assets of another corporation. Those assets can be shares of stock, real estate, patents, copyrights, brand names or anything else of value.
Why Add a Holding Company to Your Business?
Suppose you are a small business owner who has become relatively successful and has built up some retained profits in your organization, XYZ Company. If you leave those profits in XYZ, then they are fair game for creditors if the business ever gets sued or falls delinquent on its debts. For example, if you made $300,000 last year, you could potentially lose the money if the business goes bankrupt this year. At the same time, you may not want to pull $300,000 out of XYZ as income, especially if you're planning to reinvest some of it into the business over the next couple of years. If you take the profits now, you'll end up paying personal income tax on all of the money right away.
This leaves you with a dilemma: You don't want to keep the money in your business, but you also don't want to flow it out as income. The solution here is to create a holding company – for example, one called Holdco. Holdco will own some or all of the shares in XYZ Company, but it won't perform any of its day-to-day business operations. Rather, XYZ will remain in place as your operating company: selling goods, creating profit and assuming liability for debts.
Now, the holding company you've created can receive the flow of profits from XYZ as dividends, which it is allowed to do free of tax. So, you can pull cash out of XYZ while deferring the tax liability. Holdco does not, however, assume liability for XYZ's debts. If a creditor sues because your product is faulty, he can only sue the entity that created or sold the product, which is XYZ. Since XYZ owns very few assets – you've transferred these to Holdco – you're protecting your capital from creditors.
How Does a Holding Company Provide Asset Protection?
In a typical structure, the operating company will transfer legal ownership of the business's most valuable assets to the holding corporation. Holdco will then sell or lease those assets back to the operating company. On the ground, nothing changes. Your operating company, or Opco (XYZ Company in the above example), still has access to the real estate, vehicles, machinery, patents and other assets it needs to run the business.
Regardless of the business you're in, every operating company is at risk of financial liability, lawsuits or bankruptcy. However, if you are sued with a holding company in place, the assets are protected. That's because they do not belong to the operating company that is going bankrupt or being sued. Legally, holding and subsidiary companies are separate. This means that the holding company is not liable for Opco's actions or debts. When a creditor comes knocking, you can rightfully say that Opco doesn't have any money, as all the assets belong to Holdco. Creditors can't get to Holdco through Opco because they are completely separate companies.
In many cases, you can set up a new Opco very quickly. This gives the business a much greater chance of survival after an unfortunate event.
How Does a Holding Company Reduce Tax Liabilities?
Ideally, your business will be making profits for distribution to its shareholders. You as a shareholder may not want to receive this money personally, as it would trigger a personal income tax liability when tax time rolls around. On the other hand, if you have a holding company, dividends paid to Holdco will for the most part be tax free as long as the holding company owns at least 80 percent of the shares in Opco. Opco will pay corporate tax on its profits, but the tax payable by the shareholder is essentially deferred until Holdco decides to pay a dividend to its shareholders.
In other words, when you move cash out of Opco, the money sits in Holdco without any tax implications. You can then decide to keep the money in Holdco and reinvest it in the business, or you can withdraw it as a Holdco dividend distribution and pay the tax liability at a future date. The benefit here is that you get to control the timing of the dividend payment. As long as you've structured Holdco correctly, there's no tax event when Opco flows the dividend out to Holdco.
Other Advantages of the Holding Company Structure
Besides creditor-proofing and tax deferral, creating a holding company may give you some additional benefits.
Operating Multiple Businesses
The Holdco/Opco structure is useful if you have multiple businesses or you're thinking about acquiring additional businesses and those businesses need to share assets such as real estate, trademarks, patents and vehicles. The holding company can own these assets and then rent or sell them to the various operating companies on commercial or favorable terms, depending on what the business wants to achieve. It's important that you use a qualified accountant when leasing assets to Opcos, as the rules can be complex.
Make the Business More Saleable
Suppose that Opco trades from an expensive piece of real estate that it owns. You would expect Opco's book value to be far higher than if Holdco owned the real estate and leased it to Opco. Since the book value feeds into the calculation of a sale price, a high book value might deter purchasers such as employees or family members who have limited borrowing capacity. Keeping valuable assets out of Opco can make the business more saleable when the buyer is really only interested in purchasing the true business assets that are critical to operations.
Pooling and Transferring Family Wealth
Imagine trying to give shares in multiple businesses, rental properties and other assets to each of your grandchildren. It would be a logistical nightmare. It's far simpler to issue shares in a holding company so your beneficiaries indirectly own a share of everything.
Is a Holding Company the Same as a Parent Company?
A parent company is not the same as a holding company for one major reason: Parent companies may conduct their own business operations. It's perfectly possible to have an operating company that serves as the parent for one or more operating subsidiaries. Holding companies, on the other hand, don't do anything. They exist solely to hold shares. Outside of this distinction, there's really no significant difference between the two entities.
How Does a Holding Company Make Money?
Because it doesn't do anything, a holding company can really only make money in four ways:
- Receiving a dividend from the operating companies in which it owns shares
- Lending money to its operating company and earning interest on the loans
- Leasing assets or real estate to the operating company
- Selling the stocks the holding company owns
A holding company cannot simply take money from its subsidiary operating companies, and it cannot carry out activities such as investing or operating. Any revenue-driving activities, such as sales, must be performed by the operating company. This is key. If the holding company engages in these activities, it will pierce the corporate veil. Veil piercing essentially removes the holding company's liability protection, so it can be sued for the operating company's debts.
What Are the Drawbacks of Creating a Holding Company?
The main drawback is the extra layer of complexity you introduce when you add another corporation to the company stack. Simply stated, it's another opportunity for error. You'll need to be scrupulous in keeping the holding company balance sheet, asset ownership, records and bank accounts separate from those of Opco. If the lines blur, there's a risk that the courts will declare your Holdco a sham. If, say, Holdco and Opco have the same board of directors, or Opco never bothers with board meetings, a creditor might argue that the two companies are one and the same. In this scenario, the holding company may end up liable for the claims of creditors.
How Do You Start a Holding Company?
Since a holding company structure is made up of at least two companies, you'll need to create two corporations: a Holdco and an Opco. In most cases, your current business will already be incorporated. Now, you will only need to create one new corporation to act as the holding company. On the face of it, this is a relatively simple task. You just need to follow the basic steps for starting an LLC or corporation in your state.
In reality, the process is a lot more complicated. Generally, you can found your Holdco as a corporation or a limited liability company. Which one you choose depends on a bunch of factors. What's your personal tax situation? Are you planning to bring in other owners? How many employees do you have? Are you primarily looking for a tax-friendly structure, in which case you may want to establish the Holdco in a different state?
For tax purposes, you must ensure that the Holdco acquires at least 80 percent of the stock of the Opco. This allows you to file consolidated tax returns, and Holdco can then receive the dividends tax free. If Holdco owned just 60 percent of the stock in Opco, for instance, Holdco would have to pay regular corporate tax on the dividends it received. However, if Holdco owned 80 percent of the stock, then it would not pay tax on the dividends under the double taxation rules on the basis that Opco has already paid tax once on its corporate profits.
The bottom line is: When going down the Holdco/Opco route, be sure to get a good lawyer and accountant on your side. It's extremely important to discuss your specific situation with qualified advisers before you begin.
- Investopedia: Holding Company
- Investopedia: Parent Company
- Lankford Law Firm: Owning Multiple Businesses: Do I Need To Form A Holding Company
- Upcounsel: Holding Company Structure: Everything You Need to Know
- Reference for Business: Holding Companies
- Upcounsel: How to Create a Holding Company: Everything You Need to Know