If you use a holding company to acquire the business, two effective tax planning strategies could grow your wealth quicker. We highlight these two strategies in this article.

Strategy 1: Access to Paid-Up Capital

Suppose John wants to acquire a restaurant business – Greasy Poutine Inc. – by purchasing the corporation’s shares from the old owner. The purchase price is $1 million, and John has the entire amount saved up and does a cash purchase. Also, suppose that the old owner built the company using sweat equity. His only contribution was the initial $100 he contributed to subscribe for shares of Greasy Poutine Inc.

When John purchases the shares, he will have a cost basis of $1 million. If he ever sells the company in the future, his capital gain will equal the selling price above the $1 million cost basis. However, John’s paid-up capital will only be $100 – the amount the old owner put into the company to subscribe for shares. This means that John can only extract $100 out of Greasy Poutine Inc. tax-free.

Now suppose John uses a Holding Company to acquire shares of Greasy Poutine instead of him directly acquiring the shares. John contributes $1 million to the Holding Company, which then acquires the shares of Greasy Poutine for $1 million. John now has a $1 million paid-up capital in the Holding Company. The Holding Company’s paid-up capital in Greasy Poutine is still $100. Since inter-company dividends are generally tax-free, Greasy Poutine can pay tax-free dividends up to the Holding Company. Once money gets to the Holding Company, John can then use the Holding Company’s paid-up capital to extract up to $1 million tax-free.

Strategy 2: Tax-Efficient Debt Financing

If instead, John obtains a $1 million loan to buy the shares, at an interest rate of 5%, principal repayments would have to be made from John’s after-tax income. Since personal tax rates are higher than corporate tax rates, it will cost John more money to service the debt.

Now suppose John uses a holding company instead to borrow money and acquire Greasy Poutine. After the acquisition, John can merge the Holding Company with Greasy Poutine. This will allow the company to deduct the interest expense on the acquisition loan against Greasy Poutine’s profits to save taxes. It also allows principal payments to be paid using low-taxed corporate income. Overall, it will cost John less money to service the debt.

In reality, business acquisitions are partially funded using the owner’s own money (capital) and debt. So, the holding company will allow debt to be funded using low-taxed dollars while allowing John to extract his capital contribution out of the company tax-free.