Holding Company Versus Management Company

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 (HoldCo in Accounting Parlance)

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 inherits a multistate tax footprint from every one of them. This in itself is not necessarily bad, but the state tax consequences can differ from a management company arrangement. A holding company reports its underlying activities as one taxpayer, so its state apportionment reflects the combined business activities, and you explain the pieces that aren’t each state’s (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, or HoldCo, scenario can easily be explained, at times the underwriters, or more aptly the sales prevention team, cannot wrap their heads 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 for a single-member LLC, they don’t exist. But that won’t stop them from asking. Repeatedly.

Balance Sheet

This is a minor housekeeping item, but it can create some headaches. When a holding company owns real estate directly or through a disregarded LLC, the underlying assets generally remain recorded at historical cost, adjusted for improvements, depreciation and other changes. Therefore, if you purchase a house for $500,000 and five years later it is worth $650,000, you don’t simply mark it up to $650,000 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 or 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 over these nuances since they are situational, but they are things to consider.

Holding Company Benefits

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 (our rental book, I Just Got a Rental, What Do I Do?, covers that arrangement). Holding companies are also great for the ease of transferring ownership of the underlying assets. Instead of each asset being individually transferred with various instruments, a holding company is like Santa with a big bag of stuff that moves together as one.

Moving on…

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.

A holding company absorbs all the income of the underlying entities as a matter of ownership and accounting. A management company absorbs most of the income of the underlying entities through a discretionary transaction.

As mentioned in another section, state reporting can be cleaner. Each underlying entity reports its own activity, whether on its own state tax return or apportioned to the correct states within Schedule C on your individual tax return. The management company then reports its own service revenue under the sourcing rules that apply to its business. This doesn’t automatically reduce your state income taxes, but it can simplify how each business reports its activity across state lines.

There is a catch. Some states tax gross receipts rather than net business income, such as Washington, New Mexico and Oregon, and in those states the underlying entity might pay tax on its customer revenue while the management company pays tax again on the fees it receives. Lovely! We explore this further in our Things to Work Through with Multiple Entities section.

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 excuse you from reporting the activity 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. Why? They want to verify your calculated loss is truly a loss.

A management company arrangement also allows for a lot of flexibility as we alluded to a bit ago. 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 without an S Corp election, 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 Schedule C carries a much higher examination profile than a partnership or S Corp tax return, as we cover in Chapter 1.

To compound this risk, we are shifting income to the management company with a management fee, which drives the Schedule C down to a nominal amount. Call it what it is, Management Fees, and don’t sprinkle it across Advertising, Contract Labor and Commissions. That is both wrong and exactly the pattern an examiner reads 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 risk concern is to have the underlying entities be partnerships, or in some cases S corporations. Business entity tax returns are examined far less often than individual tax returns. For tax year 2021, the IRS’s 2025 Data Book shows partnership tax returns audited around 0.1%, while individual tax returns with income between $500,000 and $1 million ran about 0.6%, and a Schedule C tends to push an individual tax return toward the higher end.

Moving the activity off your Schedule C takes it out of the line of fire. This adds the burden of additional tax returns. However, if the underlying S Corp doesn’t have material income (say $10,000 of net business income after expenses or less), and the owner’s services and compensation are handled through the management company, separate shareholder payroll at the underlying S Corp might not be necessary. Also, for those entities operating in California, you might need each underlying LLC to be taxed as an S corporation to escape the California LLC fee, which is based on gross receipts.

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 and commercial substance. Said another way, the management company needs a light-duty services agreement outlining the services provided to each underlying entity and how the fee is set, such as an hourly rate or a monthly fee, which is very flexible. Since the entities are related, the fee also needs to be what an unrelated company would charge (IRC Section 482).

The cornerstones of business purpose are the two words in IRC Section 162(a). The expense must be ordinary and necessary. Ordinary means normal and customary for a business like yours, and you would argue that management fees are as ordinary as owner wages. Necessary means appropriate and helpful to the business, not strictly indispensable, and you would argue that the expertise offered by the management company keeps the lights on.

Keep ordinary and necessary in mind since they are the primary ingredients to a legitimate business tax deduction.

Accruing the Year-End Fee

Most small businesses are cash-basis taxpayers, recording 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 profits of the underlying entities until well after December 31. So, how do we put the toothpaste back in the tube on March 1 when everything is reconciled and the financial statements are prepared?

The answer is the same one we gave in our mothership baby S Corp section. A cash-basis entity cannot accrue just its favorite expense. To deduct the fee in the year the services were performed-

• The underlying entities need to be on the accrual method.
• The fee formula needs to be fixed in the services agreement before year-end.
• The management company reports the fee as income in the same year it is deducted.

With that setup, the underlying entity records a Management Fee Payable and Management Fee Expense dated December 31, and the cash moves later. Without it, pay the fee by December 31. Either way, nothing is deferred and nothing disappears. It’s only a question of which year.

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 and 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 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 the 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 and so on), including owner salaries and distributions. What should be avoided in both arrangements is distributing money directly to the human owners from the underlying or subsidiary entities. Said differently, the money needs to double hop from the underlying entity to the holdco or mgmtco to the humans.

Here is the side-by-side-

	Holding Company	Management Company
Who owns the underlying entities	The holding company	The humans
How cash moves up	Owner distribution to the holding company	Management fee for services
Where the activity is reported	All on the holding company’s tax return	Each entity reports its own, often on Schedule C
State reporting	One taxpayer, combined apportionment	Each entity reports its own activity
Best fit	Rentals, and assets that should move together	Separate businesses that need their own identity
Watch	Liability spillover, lenders wanting tax returns that don’t exist	Schedule C audit profile, business purpose, gross receipts states