By Ron Coleman
Construction-type businesses have the highest failure rate followed by restaurants. Contractors that rely on restaurants might want to start diversifying their clientele.
The best way to start a business is by structuring the business by minimizing any type of personal risk. If the business fails, would you or your spouse be forced to declare personal bankruptcy? Is it fair that a failed business could also mean losing other assets, like your home?
Creditors want to get paid, and they can be very aggressive in getting what they are entitled to. By structuring your business correctly and by following certain rules, the chances of the business failing are significantly reduced and would limit any personal bankruptcy exposure.
Many HVAC and plumbing contractors start off with one van or truck as a sole proprietor. As the business evolves, they form a company and go from there. Very little, if any, thought is given to the long term. We expect to be in the business for the long term. It’s usually our trade expertise that gets us started, not our business acumen.
There are several advantages to forming a company rather than operating as a sole proprietor. The business is a separate legal entity from you and there are restrictions on what you can be held responsible for. Also, this is a very effective way of sheltering income from taxes. It also means that you will have separate bank accounts for the business and your personal activities so they don’t get entwined. All contracts are with the company and not you personally. It is also easier for companies to obtain liability insurance.
Forming a holding company
When installing a mechanical system, we have drawings and specifications and know what the outcome will look like and how the system will function. It’s a pity we don’t do the same with our business and allow for contingencies.
The following recommendations might not be the best from a corporate or personal tax perspective, but it will give you the best protection in the event things go sideways. There is a better than 20 per cent chance that things will go sideways.
The first suggestion would be to form a holding company. Loan it the money to start, or buy an operating company. The operating company is owned by the holding company. It’s appropriate to have your spouse as a shareholder in the holding company, but not as a director. Directors have a variety of legal obligations that shareholders don’t have. Never let your spouse sign personal guarantees.
It’s also a good idea to have your home and any other significant assets in your spouse’s name, that way they can’t be attacked for any liabilities that might be your personal responsibility. Those liabilities would include personal guarantees and trust claims.
When the operating company makes a profit, it will pay no more than 13 per cent corporate tax on profits up to $500,000. Those profits can be transferred as dividends (tax-free) to the holding company and the loans to start the business can be repaid without tax implications. Also, any profits held in the holding company are sheltered from creditors of the operating company.
If you buy a building, don’t put it in the operating company, I tend to recommend a separate holding company.
The operating company will need working capital. When the dividends are paid up to the holding company, that can leave the operating company short of cash. The holding company can loan the cash back to the operating company and put a priority charge against that debt the same way a bank would.
Some companies like to put their vehicles and equipment into the holding company and then rent them back to the operating company. This could be an issue for companies in British Columbia as there are provincial sales tax implications.
Limiting exposure
Ideally, you want the operating company to have as little tangible worth as possible as this limits the exposure to creditors.
As a director, you are responsible for the company and its performance. Many of the liabilities are the sole responsibility of the company with the directors not having any responsibility for them. However, there are a number that are considered as trust liabilities that the directors can’t avoid. For example, source deductions and GST/HST are the responsibility of the directors. The CRA is not obliged to go after all directors equally, they will likely pick the ones with the most assets.
In addition, trust claims are also involved with monies paid to the contractor to do specific projects. If the money is not used to finance the relevant project, the directors may be open to a charge of breach of trust.
Other liabilities that cannot be avoided are those where you have given personal guarantees. If you signed a personal guarantee 20 years ago with a supplier, will you remember you did? If you sell the company and the new owner gets into financial trouble, the supplier still has your personal guarantee and may try to enforce it. Make sure you cancel all personal guarantees when you sell the company.
Reach out to your accountant
I did mention that there are some tax downsides to all this. They can get quite involved, so you would definitely need to explore these with your accountant to understand the pros and cons.
For example, if you and your spouse each own shares in the operating company in your personal names, and you sell the shares to a third party, you would likely be eligible for the lifetime capital gains exemption. In 2022, that was $913,630 for each of you. If you own the shares through your holding company, the tax breaks are not as good but are significant and need to be reviewed with your accountants. Selling assets rather than shares also has tax implications that need to be understood.
If you are in business, whether established or in the early phase, I would recommend you review this article with your accountant and ask them for guidance on how you should proceed. Hope for the best; plan for the worst.