Establishing a professional operating company structure is vital for any growing business. Many entrepreneurs start as sole proprietors. However, as your revenue increases, you must transition to a more robust legal framework. A common setup involves having the operating company (“Opco”) owned by a holding company (“Holdco”). This allows you to remove excess cash from Opco without paying immediate tax. You can achieve this via inter-company, tax-free dividends.

Good Structure for Early Stage Companies

The Holdco can invest these funds after paying only a low corporate tax rate at the Opco level. Although this is a good option, I usually propose a better one to my clients. This alternative involves the use of a discretionary family Trust .

This structure still allows you to achieve tax-free dividends. However, it also offers enormous additional benefits. For example, it enables the potential multiplication of the Lifetime Capital Gains Exemption (LCGE) on a future sale. It also protects assets from personal creditors of the individual shareholders.

What is the Alternative Structure?

So what does this operating company structure look like? It is simple. Instead of the Holdco owning the Opco directly, the Trust owns the Opco. You still set up a Holdco, but it does not hold the shares of the Opco directly.

Instead, the Holdco acts as a beneficiary of the Trust. This setup allows dividends to flow from the Opco to the Trust. The Trust then flows those funds out to the Holdco. In this scenario, the Holdco remains “connected” with the Opco within the meaning of (subsection 186(4) of the Income Tax Act (Canada)). This ensures the dividends remain tax-free while the Trust avoids realizing tax by allocating income to the Holdco.

Use of the Lifetime Capital Gains Exemption

The standard Holdco-owns-Opco structure has a severe limitation regarding future sales. One goal is to remove excess cash from the Opco to protect it from creditors. However, this often causes a buildup of passive assets in the Holdco .

If you must sell the Holdco shares to access the LCGE , those passive assets might render you ineligible. In contrast, if the Trust owns the Opco shares, the Trust can sell the “pure” business shares directly. This protects your eligibility for the LCGE while keeping excess cash safe in a separate entity.

How Many Lifetime Capital Gains Exemptions Can You Use?

One of the most powerful features of this structure is that there is no limit to the number of beneficiaries who can use their LCGE. This allows for significant tax planning opportunities during a business sale. For example, in 2021, I established a structure for a family that utilized five separate exemptions.

Three years later, that family signed a Letter of Intent (LOI) to sell. They will now shelter nearly $5 million of sale proceeds from capital gains tax. This specific operating company structure resulted in approximately $1.25 million in direct tax savings. In some extreme cases, I have even seen structures where 15 different beneficiaries used their LCGEs from a single sale.

When the Trust sells the shares of an Opco, the resulting capital gain can be allocated to these various beneficiaries. Each person uses their own limit to offset the gain. Because the Holdco is not in the direct chain of the sale, its passive assets do not impact the LCGE eligibility of the Opco shares.

Creditor Protection

I will elaborate on this more in a future blog post; however, suffice it to say for now that putting your assets in a discretionary family Trust keeps them out of your personal hands directly. While you still maintain control, you do not technically own the assets. This shield protects your wealth against future personal creditors.

In this operating company structure, the value of the entire enterprise is shielded from claims against you as an individual. The Trust can also hold other investments, providing a centralized and protected hub for your family’s assets.

Just for Fun

Just for fun, here is a (redacted) email I recently sent to a client summarizing very briefly these concepts that I had just explained to them in a video meeting. This case involved two arm’s length shareholders, so there are some other nuances you might pick up on.

“Hey [Shareholder 1] and [Shareholder 2],
Nice to meet you earlier today.
Here is a very brief summary of the three options we discussed:

Option 1 – Do Nothing

1. Leave structure as the status quo. Dividends paid out to you as the owner/managers are subject to personal tax at your respective tax rates.
   • Pros: No work needed, no cost.
   • Cons: less flexibility on taking funds out in each shareholder’s respective discretion and therefore less flexibility on when to pay personal tax on such funds.

Option 2 – Holding Company Structure (No Trust)

1. Each shareholder sets up a holding corporation (“Holdco”) to hold their shares of [Opco].
2. Dividends can be paid up to each respective Holdco without realizing any tax consequence (as such dividends will be to “connected companies” within the meaning of 186(4) of the income tax act). Each individual can then choose to remove funds from their respective Holdco in their own discretion. Each individual can decide to leave excess funds in their Holdco (thus paying no tax at this stage beyond the initial low rate of corporate tax paid by [Opco] on the business income) which they can use to invest. As mentioned in the meeting when [Shareholder 2] stepped away briefly, if one’s holding company then realizes a capital gain in the future (such as, for example, on a sale of investment real estate that would have been acquired in Holdco), such Holdco would obtain a capital dividend account balance equal to half of the capital gain which essentially means an amount that the individual can remove from the company on a tax-free basis via paying a “capital” dividend.
   • Pros:
     • Relatively small reorganization, only one additional entity each.
     • Tax deferral benefits.
     • Flexibility as among shareholders to deal with their profits how they want to without affecting the other shareholder.
     • Can protect assets not needed by [Opco] from potential creditors of [Opco].
   • Cons:
     • This structure would likely eliminate the ability to utilize (or at least fully utilize) the lifetime capital gains exemption in the future, as excess cash and other passive investments would likely build up in Holdco thus rendering it offside for capital gains exemption eligibility.
     • The initial cost to implement this structure, plus the additional annual compliance required for the holding corporation (i.e., extra accounting fees) (albeit somewhat minimal)

Option 3 – Trust Structure with Holding Company

1. Each shareholder would own their shares of [Opco] through a trust. A holding company would be set up for each shareholder which would serve as a corporate beneficiary of the trust.
2. One additional company would be required for each shareholder for purely technical reasons (as explained in the meeting) – namely, such companies would exist merely to ensure that the companies are “connected” with each other to ensure inter corporate dividends are not taxed.
3. So the exact structure is that one trust for each of the individuals owns a holding company which in turn holds the shares of [Opco]. Each trust also has another corporation as a beneficiary of the trust.
   • Pros: This structure has all the benefits of option 2, except that it would not only preserve the potential to utilize the lifetime capital gains exemption but each individual can potentially multiply the capital gains exemption by having numerous beneficiaries of their trust who can each utilize their own capital gains exemptions in their capacities as beneficiaries of the trust. 
   • Cons:
     • The initial cost to set up
     • The additional annual maintenance/tax return for 2 additional companies and the trust for each of you.

On a side note, I meant to mention to you guys, that if you don’t have a shareholders’ agreement in place, I highly recommend one which would include things like a “shotgun clause”, provisions relating to what happens to a shareholders’ shares if he/she dies, loses capacity, gets divorced, etc., what happens if an offer to purchase comes along – i.e., tag-along/drag-along rights, and numerous other important clauses. This would be recommended regardless of which option above you choose. Happy to answer any questions you have about this as well.

Let me know if you have any further questions at any time.

Tnx very much.