How is it possible for you to protect yourself against a business failure? How is it possible to protect enough assets to carry on and even contemplate starting over soon after a business goes down? With the proper steps and given certain favorable circumstances, this scenario is often achievable.
Well, incorporation is undertaken for a number of reasons,
1) The dramatic savings in income tax related to earnings retained in the business,
2) The lifetime capital gains exemption associated with the disposal of shares in a private corporation,
3) Limited liability or the limitation of creditors claims to the assets retained in the business.
It is point three that is the principal consideration in creditor proofing. For purposes of this paper, creditor proofing is the act of becoming a secured creditor of your own corporation.
It provides the opportunity of ranking at the top of a list of creditors rather than ranking at the bottom.
Many of us have worked long and hard to build up our businesses and accumulate equity in them. In fact, for many of us our principal asset is the interest we hold in our private corporations. We don’t necessarily take out all of the equity because we would prefer to pay the lower rates of corporate tax than the higher personal rates.
The problem with leaving the equity in the corporation is that it can be subject to any creditor claims. Of course there is no way of getting out of our liability to the government or to the bank, who normally is first in line in the event of a bankruptcy, but there is no reason why we should not rank in priority to all the unsecured creditors (essentially our accounts payable) who we routinely do business with.
There are several ways that this could be accomplished. The easiest, if we have a shareholders loan outstanding presently is simply to secure the shareholders loan. This merely involves calling up your lawyer and registering a General Security Agreement against the business for the amount of the loan.
But let’s say that the business has been self financing and that we have a huge amount accumulated in retained earnings and no shareholder’s loan outstanding. How do we convert the retained earnings to a shareholder’s loan? The answer is with the implementation of a holding company.
Dividends can be paid between Canadian corporations in most cases on a tax free basis.
The above point is critical since it enables us to strip out the retained earnings with no tax consequences.
The steps involved in accomplishing this would be as follows,
1) Incorporate a holding company
2) Transfer the shares of the operating company into the holding company
3) Declare a dividend between the operating company and the holding company
4) Lend the money back to the operating company
5) Register security for the amount of the loan, or some greater amount if you anticipate declaring dividends on a recurring basis.
There are three points to be concerned about,
1) Insuring that you have adequate retained earnings to cover the amount of the dividend. The program will not work if you generate a deficit.
2) Insuring that you do not antagonize the bank or a significant supplier who might have covenants on the business.
3) Since you are not dealing at arms length with your company, the security is not immediately enforceable. Normally, the security is fully enforceable six months after registration. It is often a question of all the facts surrounding the security. Obviously courts would look quite cynically in the event that a company went broke one week after a principal shareholder registered security.
These issues can be covered off with a careful review of your situation. It is generally a good idea to communicate with the bank in advance to make sure that they are onside with your intentions.
I wish to emphasize that it is the holding company that holds the security. Assuming that you get paid out if the operating company goes bankrupt, the funds would end up in the holding company. You could then draw them out over a period of time if you needed the money to live on, and limit the personal tax, or you could use the funds to start up a new business.
Each situation has to be dealt with on its own merits. A careful review of the company’s circumstances with a tax and legal professional should be performed before this task is undertaken.
In conclusion, I hope that the above has been informative and will be happy to provide additional information upon request.