I got to know a successful businessman. He had annual sales of $5,000,000 a year. He had two front companies called XYZ Sales Ltd. and XYZ Service Ltd. to handle the clients. “Sales” sold the machines; “Service” maintained them after the sale. He had three holding companies that owned various shares in the two front companies. He owned the shares in the holding companies.
He was shuffling money around the five companies to reduce his taxes. He would adjust “salaries & dividends” between the companies, which I talked about in Part 1 of this series.
Having this corporate structure is not as easy as it sounds. First, each company had to be set up as a formal corporation, let’s say $5000 for the group. Then, each year, each company had to file annual tax returns to the government. I estimate the filing fees for the holding companies were probably $1000 a year; the front companies were $3,000 each. And the corporate minute books for all five companies had to kept up to date with all the “big decisions,” like management salaries and dividends. So probably two or three sets of minutes for each company for each year, maybe $200 per minute.
I also imagine that some of his customers might be a little annoyed dealing with two companies, instead of one.
As the businessman explained this to me, I could only wonder why not just have one company. Focus on the business, not tax minimization. He would have still had the “salary vs dividend” tool to reduce taxes. Was there enough tax reduction happening in the five companies to pay these extra accounting and legal expenses?
I don’t know. But this businessman did not like paying taxes. So this five-company setup was probably more his way of “getting even” with the government than actually saving money. For sure, his accountants and lawyers were getting a little richer.
Many successful business owners have one holding company. Holding companies usually hold shares in the front company, which is doing the actual business.
Dividends moving from one corporation to another are not taxed. So money moving from a front company to the holding company is tax-exempt. Some readers will be aghast with this knowledge, and I’ll get to this later.
In essence, the “business empire” can store untaxed money in a holding company. This money can earn interest. Or it can be invested elsewhere.
Holding companies can become a possible source of cash for the owner or the front company. For example, the business owner can draw a salary from the holding company rather than the front company. This might be useful in hard times, so the front company is more likely to survive.
Having a holding company is another opportunity to play another salary vs. dividend game to reduce overall taxes. Maybe another 20% reduction is possible with a holding company.
The holding company can provide loans to the front company. Interest payments are kept within the owner’s business empire rather than going to a bank.
The holding company can spawn new business units or take on the role of a venture capitalist. If so, the holding company can buy shares in that new business. If that business grows, that is good for the holding company and its owner.
Holding companies can become useful if the front company is sold. Such a sale often results in a capital gain (the difference between the business sale price and what the owner originally put into the company). Capital gains are subject to taxes with its own special rules. A business owner with a holding company between him and the front company has more legal tax reduction tools than a business owner holding shares in his front company. For example, the holding company can delay the capital gain over several years rather than being taxed in the year of the sale.
These are the advantages for a business owner to use a holding company to “support” his front company.
First, let’s just make my position clear.
If a holding company earns a corporate profit, it should pay taxes on that profit, according to current tax rules. It should not matter if the holding company did or did not move money to the owner.
When money — either as salary or dividends — moves from the holding company to the owner, the owner should be taxed, according to current tax rules.
With a holding company, the entrepreneur keeps his personal accounts, business accounts, and investment accounts separate. The entrepreneur can think straighter when these three aspects of the owner’s life are not meshed together. The entrepreneur can focus on the front company, which is the ultimate source of his profit and livelihood. Affairs in the front company are usually a daily affair, whereas affairs in the holding company need to be looked at a few times a year. In essence, the holding company reduces distractions for the front company.
The tax reduction benefits of a holding company are there. The holding company will not drastically cut the total tax bill the entrepreneur has to pay, maybe another 20% reduction. But remember that this tax saving has incurred additional expenses to keep the holding company operating in a proper legal way.
If an entrepreneur has more than one holding company, that probably means he is spending too much time on tax reduction — and not enough time on the front company. There is a lot of calculating (or paying someone to calculate) to figure out the best legal tax reduction of two front companies and three holding companies. Instead, that energy should be going to analyze the business numbers of the business.
And, in my opinion, a second front company is only warranted when the business units are different from each other. For the business that inspired this article, XYZ Sales Ltd. and XYZ Service Ltd. were not that different.
If there are any tax auditors reading this article, focus on the entrepreneurs who have multiple holding companies and multiple front companies. These entrepreneurs are more likely to engage in tax reduction that is not so legal.
I have owned two corporations. Neither was successful.
My first corporation (1985–1992) did have small profits and paid some corporate tax. I had some outside shareholders, and small dividends were paid to them. When I shut down that company, I was able to claim $45,000 in business losses, which I applied against my later “wage-earner” taxes. In essence, my accountants used the losses to reduce my later wage income to the first tax bracket, which means I did not pay taxes for two years. My shareholders also claimed a business loss of their original investment in this company.
The second corporation (1991–1993) held my second business unit. My business loss was about $5,000. The government seemed to accept the demise of my first corporation. But I got many notices from the government admonishing me for not filing a tax return for the second corporation. I tried to explain the demise in a letter to the government, but I got more letters. These letters continued for several years. I could have been taken to tax court. I probably would have won, but that would have been a hassle and an expense I did not need. The lesson: don’t incorporate a business unit unless there is a good reason. A proprietorship could have handled this business unit.
Since 1996, I have put my business dealings through a proprietorship. I have had technical writing and teaching contracts under that proprietorship. These days, I have tutoring revenue. My meagre e-book sales and my meagre Medium revenue go to that proprietorship. Some years, the business makes a little profit — and that profit gets reported in my personal income, so I pay taxes on it. Other years, the business operates as a loss — and I use that loss to reduce my personal taxes. It is quite easy to move my proprietorship’s profit/loss calculation to my personal tax return, which adds $100 to my personal accounting fees. The proprietorship does not file a separate tax return.
As I alluded to the previous article, a proprietorship can be officially recognized by the government. Or the business can run without any recognition. I chose the official path. With that recognition, I was able to get a bank account separate from my personal account. All my business transactions go through this proprietorship, not mixed in with my personal banking.
Having a side business, I am audited every four years or so. Because my bookkeeping is straight forward, it does not take me long to find the receipts the auditor is looking for. I give the receipts to my accountant, and he deals with the auditor. I have passed all my audits. If the auditor ever looks at my books, he will only see business transactions that cannot be confused with personal transactions.
As well, the proprietorship provides a trade name that my customers and vendors can identify with. “Dave Volek Publishing” sounds more business-like than “Dave Volek.”
But it would be pointless to incorporate this proprietorship until it consistently earns a profit of $100,000 a year.
I have two “consultative” board games on my inventor’s drafting board. If my alternative democracy provides a little fame and fortune, I will use that fame and fortune to promote these games. I would likely incorporate this business unit, separate from my proprietorship and my personal account. This incorporation will allow for an easier sale of this business unit. If the business unit brings in $100,000 profit, I might put a holding company in place. As I am now a senior citizen, I believe the holding company will give my estate some more options. Yes, I will take advantage of the tax reductions, but these considerations are secondary.
For sure, I will not be building a convoluted business empire. One holding company is enough.
Published on Medium 2024
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