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Holding Company versus Management Company
By Jason Watson, CPA
Posted Friday, October 20, 2023
We’ve discussed this in a roundabout way, but this section hopefully ties some concepts together. 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.
The Holding Company
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.
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.
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).
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, they don’t exist.
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. Therefore, 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.
The Management Company
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 bragging rights.
As mentioned above, and elsewhere in our book, 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).
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 (for example, the 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.
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.
The Flow of Money
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.
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