C Corporation as Mothership

By Jason Watson, CPA
Posted Saturday, June 22, 2024

The past handful of sections have discussed the various considerations of the mothership baby S Corp multi-entity arrangement. Another consideration is rather than the mothership being a multi-member limited liability company (MMLLC), it is a for-profit C corporation. Owners would be shareholders versus members / partners. Entity governance would be Articles of Incorporation with Bylaws and Shareholder Agreements versus Articles of Formation or Organization and Operating Agreements. Gee whiz, right?

Hang in there… here are the things to think about with a C Corp as the mothership.

Paying Members for Services

Section 707(a)(1) of the Internal Revenue Code reads-

(a) Partner not acting in capacity as partner
(1) In general
If a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner.

This doesn’t really tell us much, but there is some case law that suggests that the member must provide services to the LLC that are different from the activities for which the LLC was created or operated. For example, let’s say a partner provided accounting services to a CPA firm by preparing a tax return for the firm’s client. This suggests that the services provided are the same as the activities of the LLC.

However, there is case law suggesting that paying this same partner is not a problem at all. Slightly different facts with slightly different courts with all human nuances you would expect.

Keep in mind that the mothership baby S Corp does not avoid or reduce taxable income and therefore does not impact income taxes. Moreover, self-employment taxes might be reduced, sure, but they are reduced if the mothership elects to be taxed as an S Corp just the same (without the baby S Corps). As such, how is the IRS damaged?

Having said all this, a C corporation where you have shareholders (and not LLC members) might sidestep Section 707’s interpretive concern.

No Mothership K-1

Corporations naturally do not issue K-1s. This in itself might not be that exciting, but it does shrink the mothership owners’ tax footprint. If the entity is operating in California but one owner lives in Texas, and the entity issues a K-1 albeit a small one it still allows California to snoop around. They love to snoop and make wild assumptions.

Increasing Working Capital

When you increase working capital in a MMLLC, this usually increases net ordinary income on the K-1 issued to each member. As such, there is taxable income without cash, and that taxable income is computed at individual tax rates with the highest bracket being 37% federally. A C Corp would only pay 21% to increase working capital.

Why does increasing working capital increase income? In a mothership baby S Corp environment, profits are driven down close to zero with payments to the baby S Corps. This requires cash. Therefore, retaining cash prevents the mothership from reducing profits with payments to the baby S Corps. Sure, you could accrue the expense as a liability without cash leaving, but that can get challenging to reverse (make the payment) in future years without creating the very problem you are trying to avoid.

Using a line of credit solves might solve the working capital taxable income conundrum since the delta between 37% and 21% is likely to be higher than the tax-effected interest expense. Something to consider.

Ancillary Benefits

As mentioned in other parts of the book, a corporation allows you to issue stock to employees without the mess of member interest and the subsequent K-1 of an LLC.

The corporation might qualify for the Qualified Small Business Stock (QSBS) exemption upon sale. Loosely, Section 1202 of the Internal Revenue Code offers taxpayers (other than corporations) the potential to permanently exclude from taxable income $10 million om capital gains recognized in connection with the sale of the corporation. Yes, there are rules.

Summary

Here is a summary of the various scenarios in a multi-entity arrangement using the mothership baby S Corp construct-

• The mothership is an LLC and each member is an S corporation (the baby S Corps holds the interest in the LLC). This can be bad if crossing state lines between mothership and baby S Corp.

• The mothership is an LLC and pays a fee for service or management fee to the baby S Corps. This might be bad given some of the interpretations of Section 707.

• The mothership is a C corporation and pays a fee for service or management fee to the baby S Corps. All the taste of the mothership baby S Corp environment without the possible calories of Section 707, plus all the benefits above.