Business owners and shareholders are always laser-focused on making sure their enterprise is growing and profitable. While steering a business’s day-to-day operations is the primary focus of an owner, protecting that business’s assets come in a close second.
While there have been various ways that have been created to accomplish this goal of protecting a business’s assets, one of the more popular asset-protection strategies continues to be the creation of a holding company.
What is a holding company?
A holding company’s job is to hold the controlling stock or membership interests in other companies. Or put another way, the holding company owns (holds) and controls the assets of subsidiary companies. It’s a parent business entity, most commonly a corporation or a limited liability company, that isn’t a typical business – it doesn’t make anything or sell anything.
The subsidiaries of a holding company are the entities that actually take part in manufacturing, selling products and services, and carrying on the typical day-to-day operations of an enterprise. These subsidiaries are often referred to as operating companies.
The holding company can own 100% of its subsidiaries, or it can own a portion of the subsidiary, usually enough stock or membership interest to control the subsidiary. When there are several owners or shareholders, a holding company might have 51% ownership interest. In situations where there are many owners, the holding company could have a much lower ownership interest and still retain control of the subsidiary.
Because the holding company usually owns a majority share of all subsidiaries, the holding company can dictate the day-to-day operations of the subsidiaries, including electing and/or removing corporate directors or other managers and can make major policy decisions on behalf of the subsidiaries.
While the individuals in charge of the holding company can direct the activity of subsidiaries, they normally do not participate in the day-to-day operation of the subsidiaries.
How a holding company is used
Some of the well-known publicly traded corporations are actually holding companies with a diverse range of subsidiaries. Instead of existing as one corporation with several divisions, the business is structured as one holding company with several subsidiaries.
Lest you think that holding companies are only for sophisticated, multi-national corporations, smaller businesses also organize as a holding company, including many, many self-employed entrepreneurs.
For example, say an attorney wants to start a business providing legal services. The attorney decides to form an LLC for the legal services business (Schedule C on Form 1040 would be used to file this business’s tax return. We’ll refer to this first LLC as LLC1).
After a couple of years of renting an office space in a local professional building, the attorney decides to relocate to a building that he or she recently purchased. After buying the building, the attorney creates a second LLC, completely separate from the legal services business, that would own the recently purchased building (We’ll refer to this second LLC as LLC2).
There are now two business entities: LLC2 owns the apartment building, while LLC1 would serve as the holding company that would own LLC2.
The legal services business provides a steady cash flow to the attorney over the next few years. The attorney then decides it’s time to look for another business to invest in and decides on a fast-food restaurant franchise. The attorney sells shares in the holding company (LLC1), then takes the money from selling those shares and purchases the restaurant franchise, which is structured as a third LLC (LLC3).
The attorney can continue creating new subsidiary LLCs under the holding company for each new subsequent investment.
What is the benefit of a holding company?
Here are several reasons why holding companies are used, continuing with our legal services business as an example:
When our attorney formed his legal services business, organizing as an LLC ensures that creditors and claimants from potential lawsuits can’t go after his personal assets to satisfy the creditor or lawsuit judgment.
Holding companies also offer advantages for their operating entities. If the attorney in our example keeps adding operating subsidiary LLCs under the holding company, placing each operating entity and the assets it uses in separate entities provides a liability shield.
The debts of each operating entity also belong exclusively to that subsidiary. A creditor of one subsidiary cannot touch the assets of the holding company or another subsidiary to satisfy a debt.
Further discussion on liability protection
LLCs and corporations can help a business owner protect their personal assets if the business runs into trouble and gets sued. But while a business owner can protect their personal assets from creditors or potential lawsuits, can anything be done to also help protect the business’s assets? How can you protect both personal and business assets from creditors and lawsuit judgments?
This is where the holding company comes into play – an operating entity that uses and possesses a business’s assets on a daily basis but DOES NOT OWN the assets, and a holding company that actually does own the assets.
While liability protection may be the most important feature of a holding company, there are several other advantages that this type of business structure can provide for its owners:
- Control more subsidiaries for less money: A holding company can control the day-to-day activities of a subsidiary without owning all the assets or membership interest. The holding company simply needs to own a majority of the assets or voting interests. This allows the holding company to own the subsidiary at a lower cost than if it had obtained 100% of the subsidiaries assets or voting interests.
- Favorable debt financing costs: A holding company can use its combined balance sheet, which may include multiple subsidiaries, to obtain a loan for use by only one of the subsidiaries. The holding company would likely get more favorable loan terms than if the subsidiary had attempted to secure the loan on its own.
- Day-to-day management is not necessary: The subsidiaries obviously need management to run the day-to-day operations of that subsidiary. But the management of the holding company often doesn’t need to be involved with the holding company on a day-to-day basis and doesn’t even have to be experts in each subsidiary’s industry.
While holding companies have the aforementioned advantages, there are some tradeoffs when using this type of structure:
- Ongoing legal and compliance costs. Each holding company must first be created as a distinct legal entity, usually an LLC or a C corporation. This involves paperwork, filing costs, and ongoing maintenance. Even though holding companies are normally not operating entities, they still usually have to file tax returns, both at the federal and state levels.
- Dealing with minority owners. One of the advantages of a holding company – not needing to own all of a subsidiary’s ownership interests, can also be a disadvantage. When a holding company does not own 100% of a subsidiary, it will need to work with the minority owners if the interests of the minority owners are not the same as those interests of the holding company.
Holding Company Taxation
A holding company and its subsidiaries, as previously mentioned, are completely separate business and legal entities. As such, each entity files its own tax return and pays its own taxes on its own income.
The IRS has rules in place to deter parent and subsidiary companies from moving taxable income around among each other. Starting in 2013, an international subsidiary cannot use American intellectual property without paying the parent company. A parent company is not liable for subsidiary taxes only if it’s obvious that the two are operating independently. If the IRS sees that the two companies are actually one, it will ask for back taxes.
Strategies in Deferring Taxes
- Many shareholders. Creating a holding company for each shareholder in your corporation can give flexibility to each shareholder. Each holding company controls the dividend payments to each person.
- Splitting income. The holding company can be owned by more than one person. This allows the dividend payments and taxes on them to be divided.
- Create a trust. The shares of the company can be helpful in a family trust. You, your spouse, your children, and your holding company will benefit from this arrangement. Dividends can be distributed to your holding company as a beneficiary, and they are usually tax-free.
- Creditor protection. Profits from your company can be sent to the holding company in the form of dividends, and they can be sent back to the business if cash is needed. Any profits will not go to creditors but will stay within the business.
- Retirement funds. The assets within your holding company represent a type of pension that you can use once you are ready to retire.
Beware the Personal Holding Company Trap
As mentioned in the first section of this article, a holding company can serve legitimate purposes by helping to organize subsidiaries, providing liability protection for those subsidiaries, and offering several tax planning opportunities for the owners of the holding company.
If your holding company is organized as a C corporation, however, you should be aware of the “Personal Holding Company” tax trap.
What is a Personal Holding Company?
A personal holding company (PHC) is a C corporation in which more than 50% of its outstanding stock is either directly or indirectly owned by five or fewer individuals, and which earns at least 60% of its adjusted ordinary gross income from passive sources.
Because the top corporate tax rates have been historically lower than the top individual tax brackets, shareholders of some C corporations tried to keep retained earnings within the corporation to get taxed at the lower corporate rate, instead of distributing these earnings to the shareholders and getting taxed at a higher individual tax rate. (NOTE: The Tax Cuts and Jobs Act of 2017 cut the top corporate tax rate from 35% to 21%, creating an even wider gap between the corporate tax rate and the current top individual tax rate of 37%.)
To prevent shareholders from shielding a corporation’s earnings from the higher individual tax rates, Congress enacted a penalty on C corporations that meet the criteria for a “Personal Holding Company.”
What is the Personal Holding Company tax?
The personal holding company tax (PHC tax) is levied on the undistributed income of C corporations whose primary purpose is to serve as a tax shield for passive income. For many business owners who use a holding company for purposes of liability protection of active business operations, the PHC tax usually never comes into play. On the other hand, the PHC tax is aimed at closely held corporations that earn a substantial amount of income from investments such as interest, dividends, rents and royalties.
Avoiding the PHC Tax
C corporations should monitor their accumulated earnings throughout the year and the types of income that are earned to spot potential exposure to the PHC tax. Here are some strategies to avoid the PHC tax:
- Increase the number of shareholders. The PHC tax only applies to C corporations that have more than 50% of their stock owned by five or fewer individuals during the last half of the tax year. So to avoid being labeled as a PHC, you could see if there’s a way to make sure the top five owners of your C corporation own less than 50% of the outstanding stock. One solution could be to gift some of the corporation’s stock to family members. Keep in mind stock owned by certain family members like your spouse or siblings could be considered as owned by you. Be sure to get professional advice if considering this approach.
- Increase business income or decrease passive income. Your C corporation is only subject to the PHC tax if at least 60% of your corporation’s adjusted ordinary gross income is considered PHC income. You can do several things to decrease this 60% ratio: 1.) Either increase business income for a particular tax year by accelerating year-end sales or postponing expenses or cost of goods sold purchases; 2.) Invest in other operating activities that yield additional revenue that is not considered PHC income; 3.) Decrease PHC income by either converting securities that pay dividends to securities that do not pay dividends on a regular basis, or issuing dividends to shareholders.
Converting to an S corporation may also not be the answer for how to avoid the PHC tax. While the tax is only levied on C corporations, converting your business from a C corporation to an S corporation may also result in a tax on excess passive income. An S corporation that has earnings and profits from when it was a C corporation and has more than 25% of its gross receipts from PHC income sources could be hit with a 35% tax on the excess investment income.
When setting up a holding company, you may never have the intention of shielding investment income from taxes. But you must stay alert, however, as some years your holding company could be caught in the PHC tax trap.
Speak to our team of expert CPAs to help you with tax and accounting for your holding company.
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