Posted Thursday, August 24, 2023

Holding companies and management companies are not the same thing. One, as the name suggests, holds or owns underlying assets (other businesses). The other offers management services in exchange for fees, and typically doesn’t own underlying assets.

Quite a few entrepreneurs have their hands in a lot of pots, and for various reasons they want to set up multiple entities (typically limited liability companies or LLCs). They might want separate liability protection in their contracts. One entity might have multiple owners or have a separate team of employees with future minority owners. One of the entities might be regulated such as real estate or financial services. Yet another entity might be in a growth phase for a business sale.

Compartmentalization can be important as well to those who like straight lines and organization.

As you might already know, naked LLCs might be tax inefficient since your business profits are taxed both at the self-employment tax level and at the income tax level. However, taking all these various business units or entities, and slapping an S Corp election on each of them is also super inefficient. Multiple S corporation tax returns (Form 1120S) and multiple payroll systems are the two biggies because of the extra associated professional fees. Plus, you have the real chance of overpaying the employer portion of Social Security (that is another article all together).

What can be done? Well, you probably guessed it by now… you set up a holding company or management company in a multi-entity arrangement to achieve both compartmentalization of the business units with tax efficiency (and professional fees efficiency… ie, tax return and payroll processing fees). Win win!

In the holding company scenario, each underlying entity is wholly owned by the holding company. Since these entities are usually single-member LLCs, they are disregarded for tax purposes and their owner (the holding company) absorbs all the revenue and expenses.

This seems simple enough, but it can also open several cans of worms.

Liability Protection
While the liability protection in LLCs is largely contractual (as opposed to torts and bad acts), if an underlying entity gets sued there is a possibility that the holding company gets dragged into the mess and all its assets (the other entities) might be pulled in as well. This is attorney stuff for sure, and you should review your unique situation with a qualified one.

State Nexus
If some of your underlying business activities are operating in multiple states, the holding company might have a multi-state tax footprint. This in itself is not bad, and with a management company, you are not subject to more or less state income tax. However, with a holding company you cannot control the narrative as easily (more on this in a bit).

Credit Worthiness
At times one of the entities might need to obtain credit independently to buy some equipment or enter into a contract such as a lease. While the holding company scenario can easily be explained, at times the underwriters or more aptly said, the sales prevention team, cannot wrap their head around a holding company tax return as it compares to the underlying entity’s set of books and financial records. In other words, they want tax returns for the entity, and as a single-member LLC, one doesn’t exist.

Balance Sheet
This is a minor housekeeping item, but it can create some headaches. When a holding company owns other assets such as real estate, portfolio investments or other entities, it books that asset at the historical purchase price. So if you purchase a house for $500,000 and five years later it is worth $650,000 it will still show as $500,000 on the holding company’s balance sheet. No biggie. However, if a holding company owns a piece of another business, do you record the initial investment? Sure, but what about subsequent fluctuations in the investment / capital account? Do we use a fair value calculation? Mark to market elections for portfolio investments? What if we are using this data to create a personal financial statement (PFS) for borrowing purposes? All kinds of fun, right? Please don’t get too worked up on these nuances since they are situational, but they are things to consider.

Not all is bad with a holding company. For rental real estate, it can work well where each rental is owned by an LLC and each LLC is owned by a holding company. Holding companies are also great for the ease of transferring ownership of the underlying assets; instead of each asset being individually transferred or transitioned with various instruments, a holding company is like Santa with a big bag of stuff that moves together as one.

A management company arrangement stands in contrast to a holding company since all the associated entities remain owned by “the humans.” For example, you would personally own the home building entity and the hard-money lending company as well as the management company as three separate entities. The home building entity would pay a management fee to the management company, and same with the lending company.

This in essence pumps all the income through the management company which naturally is taxed as an S corporation for tax efficiency and cocktail party fodder.

As mentioned above, state nexus is more controlled. Each entity might have to file a state income tax return or at least have the business activity apportioned to the correct states within Schedule C on your individual tax return. Additionally, the management company might have state nexus based on the fee earned from the underlying entity. Again, this doesn’t alter your state income tax footprint, but it does cut down on what the state sees (let’s make them work at it a bit, right?). Some states are very aggressive and proving your calculations can be a pain with the holding company arrangement. No, creating a loss within the underlying entity does not preclude you from having to report the activities to the state (think rentals… a taxing jurisdiction has the right to audit your revenue and expenses even when combined they end in a loss).

An underlying entity with a management company arrangement also allows for a lot of flexibility. In a holding company situation, all the activities are brought into the holding company. You don’t have a choice, and there might be times when this is not desirable. With a management company, you dictate how much of a fee is paid and all the underlying activities are encapsulated away from the management company.

The management company arrangement has some warts too.

Schedule C Audit Risk
Using our home building entity example above, this entity would likely be a single-member LLC and as such would be disregarded for tax purposes. In turn, these activities would be reported on Schedule C of your individual tax return (Form 1040). That in itself is not a big deal, but the audit risk of a Schedule C is much higher than the holding company S Corp.

To compound this risk is the fact that we are wanting to shift income to the management company with a management fee. You could tuck this into Advertising or Contract Labor or plainly as Management Fee on the Schedule C. You might even sprinkle it around between these expense categories. Perhaps work Commissions and Fees into the mix. Either way, you are driving income down to a nominal amount with expenses the IRS loves to snoop into like the Pink Panther. If you love audits, call your management fee Meals or Travel; that will get the IRS juices flowing for sure.

A solution to the audit rate risk concern is to have the underlying entities either be partnerships themselves, or in some cases S corporations. This would add the burden of additional tax returns. However, if the S Corp doesn’t have material income (let’s say $10,000 net ordinary income or less) shareholder payroll can be avoided. The audit rate of partnerships and S corporations is about a tenth of a Schedule C (0.4% versus 4%). Also, for those entities operating in California, you might need each underlying LLC to be taxed as an S corporation to reduce the LLC fee (which is based on gross receipts if not an S Corp).

Business Purpose
This concern is not a massive one, but the arrangement between the underlying entities and the management company must have a business purpose or commercial substance. Said in another way, the management company would likely need a light duty contract outlining the services being provided to the underlying entity, and the associated fee such as an hourly rate which is very flexible.

The cornerstones of business purpose are- the expenditure (management fee) must be ordinary and necessary. Ordinary is an expense that everyone in your industry incurs and you would argue that owner wages or management fees are synonymous. Necessary is an expense that must be incurred to maintain operations and you would argue that the expertise offered by the management company keeps the lights on.

Hybrid Accounting
Most small businesses are cash-based taxpayers, and record an expense when cash leaves the checking account or a credit card is swiped. The accounting conundrum with the management company arrangement is that you usually don’t know the taxable business profits of the underlying entities until well after December 31. So, how do we put toothpaste back in the tube on March 1 when we have everything reconciled and financial statements are prepared?

The accounting industry and the IRS allow for a hybrid accounting system where accruals are used in a cash-based world provided it is consistently applied each year and does not attempt to artificially reduce taxes. The biggest example is employer 401k contributions. It is common to record a 401k Liability (the credit) and the associated 401k Expense (the debit) on a tax return since cash didn’t leave until after December 31.

Using the 401k example above, we would record a Management Fee Payable and Management Fee Expense with a date of December 31, and then have the money move at some point after. One of the principles in accounting is the matching principle where expenses associated with revenue are recorded in the same period; the hybrid accounting system described above buttresses this principle.

In either situation, holding company or management company, the subsidiary entities or business units have their own business checking accounts to receive direct payments to pay expenses specific to themselves. Next, leftover cash is moved to the holding company or management company. In a holding company, this money movement is referred to an owner distribution since the holding company is the owner (not the humans). In a management company, this money movement is simply a management fee or some similar expense in a business-to-business transaction.

Regardless of holding versus management company arrangement, the money temporarily lands there to pay overall common expenses (such as tax return preparation, legal expenses, Accountable Plan reimbursements, etc.) including owner salaries and / or distributions. What should be avoided in both arrangements is to distribute money directly to the human owners at the underlying / subsidiary entities. Said differently, the money needs to double hop from underlying entity to holdco / mgmtco to humans.

WCG does not have a strong preference between the holding company and the management company arrangements, but if tortured and compelled the management company arrangement is preferred unless there is a unique fact or circumstance that causes the holding company to stand out. One common example mentioned above is the holding company which owns a bunch of entities which owns rental properties. The holding company in turn is held in a trust.

While certain facts and situations might cause this to vary, the entity selection for a holding company or a management company is quite simple. If earned income is going through the entity, it should be an LLC taxed as an S corporation. If it is has passive income going through it such as rental income or investment income, or passive income, then it is usually a single-member LLC or a multi-member LLC (partnership).

If you have your rentals paying a management fee to your management company, this will change the color of money by converting passive income into earned income. Earned income is subject to Social Security and Medicare taxes where passive income is not taxed in this manner (it might be subject to the Net Investment Income Tax however). Converting passive income into earned income can be desirable by creating a tax deferral with a SEP IRA or 401k contribution. In other words, you pay 15.3% in self-employment taxes (Social Security and Medicare) within your management company but you defer at 42-45% (37% + state tax rate). Something to consider after some tax planning.

You could also have both a management company and a holding company (since they can serve different purposes). A management company arrangement for all your earned income from consulting, selling widgets, etc. and a holding company for all your rentals that you accumulated with your earned income. Yay!

Not sure how to set up your new entity and the structure? Concerned that you might screw it up and be forever locked into a messy situation (which is not true, but let’s play on your fears for a second)? Let’s schedule a consultation to learn your objectives today and build a system that is malleable, protective and tax-efficient.

WCG is a full service consultation and tax preparation firm, and we look forward to working with you!