There are many reasons to run your corporation as two different corporations. The downside is the complexity of running two businesses that are seemingly side by side, however the tax savings can be extremely beneficial.
In addition to the liability (asset protection) benefits and other nontax reasons that cause shareholders to use two or more corporations to carry on their business activities, the following tax advantages may be sought or achieved:
Establishing separate entities to use different accounting methods, tax years, depreciation methods, inventory valuation methods, and the foreign tax credit.
Shifting activities to obtain a more favorable tax regime than the rest of the taxpayer’s activities (e.g., segregating foreign-source income in a separate corporation subject to special rules).
Avoiding personal holding company status by segregating activities (such as renting) that can qualify for exemption by themselves but that can taint other activities.
Segregating S-Corporation activities into other entities to allow ownership or capital structures (e.g., foreign shareholders or preferred stock) not permitted under the S-Corporation eligibility rules.
Planning for anticipated or potential sales, mergers, liquidations, interfamily gifts or bequests, and other transactions adjustments that can be completed at low or no tax cost if confined to assets segregated in a separate corporation.
SEGREGATING ACTIVITIES TO LIMIT LIABILITIES
An important reason for owning multiple corporations is to segregate activities in order to limit liability. Limiting liability is critical in businesses that have a high risk of lawsuits (e.g., oil and gas drilling operations or transportation of hazardous material). Limited liability can also be critical for projects requiring substantial financing, such as real estate development. See section 101 for more discussion of assessing the liability protection factors.
INSULATING LOW-RISK ASSETS FROM HIGH-RISK ASSETS
If related activities are controlled by the same corporation, it may be advisable to form separate corporations to insulate the assets of one operation from potential lawsuit or loss by the high-risk activity of another operation. (Additionally, a creditor or major supplier occasionally prefers that different operations be separately incorporated for the same reason.) For example, if a corporation owns $500,000 of marketable securities, an operating business, and an undeveloped tract of land, the securities are exposed to the debts arising from the business operations and from the land. Therefore, subject to concerns about the costs and tax implications of using multiple entities, it is generally preferable to isolate risky assets in separate business entities.
MAXIMIZING ORDINARY LOSSES ON STOCK DISPOSITIONS
IRC §1244 allows ordinary (rather than capital) loss treatment on the disposition of qualifying small business stock, subject to certain limitations. Unfortunately, the annual limitation on Section 1244 losses applies on a per individual, not a per corporation, basis. Nevertheless, in some cases, forming more than one corporation can maximize ordinary loss treatment. If separate locations are operated through a single corporation, the failed location’s decline in value will offset potential capital gain on the successful location(s). But if the separate locations are put into separate corporations, sale of stock in the successful corporation will generate capital gain while sale of stock in the unsuccessful corporation will generate an ordinary Section 1244 loss.
USING DIFFERENT TAX YEARS TO DEFER INCOME
Affiliated group members electing to file a consolidated return must use the same tax year. However, there are opportunities to defer income when multiple corporations with differing years do not file a consolidated return.
EXAMPLE
Bob owns all the shares of two accrual-basis Corporations, Tops, Inc., a retail shop that reports on a fiscal year ending January 31, and Shop, Inc., a consulting company that uses a fiscal year ending March 31. The corporations do not file a consolidated return. On March 31, 2014, Tops pays $2,500 to Shop for consulting services. Tops deducts the $2,500 on its corporate tax return for the year ending March 31, 2014, but Tops does not report the income until the year ending January 31, 2015.
Shops income from the sale may not be entirely deferred until the end of its fiscal year because of the estimated tax payment requirements. This transaction could be restricted under the related party rules in IRC §§267 & 707(b)(1). However, the transaction in this example is not affected by the related party rules since both corporations use the accrual method.
CLAIMING THE DIVIDENDS RECEIVED DEDUCTION
It may make sense to have both corporations own at least 20 percent of the outstanding stock of the other corporation. C-Corporation members of an affiliated group that do not (or cannot) file a consolidated return can use the 100% dividends received deduction to eliminate from taxable income dividends received from another member of the group [IRC § 243(a)(3)]. For this purpose, an affiliated group is defined in IRC § 243(b)(2) and Reg. 1.243-4(b).
What all that means is if you have two corporations they could own 20 percent of the outstanding shares of the other corporation. Any dividends paid by one corporation to the other corporation would be 80 percent or 70 percent deductible.
USING A COMBINATION OF ENTITIES FOR BUSINESS ACQUISITIONS
Even for the smallest deals, it normally makes good sense to acquire a business through a newly formed entity. Given the relatively low legal cost for creating an entity, the additional liability protection gained is well worth it. The basic idea is to form an entity that is separate from any other business interests or assets owned by the buyer and use it to acquire the selling business. This logic still holds true even when the buyer is purchasing assets only. After all, why risk tainting existing assets with possible hidden liabilities when this risk can be compartmentalized inside of a new entity?
The legal concept is for the buyer to directly own two brother-sister entities that do not have any direct legal ties to each other. The main operating entity will be a C-Corporation, and a separate pass-through entity, such as a limited partnership or LLC, will finance the operating C-Corporation. If the arm’s-length legal relationships between the C-Corporation and the pass-through entity are properly documented and maintained, this structure should shield the assets of the pass-through entity from lawsuits arising from the C-Corporation’s operations.
The plan is to use the best attributes of both the C-Corporation and pass-through entity forms. For example, the operating C-Corporation can be used to:
Pay a salary to the owner and family members.
Deduct statutory fringe benefits for the owners.
Create opportunities for making deductible payments of interest, rent, and royalties to the family pass-through entity.
Build goodwill value by using the lower graduated corporate tax rates
Eventually bail out at long-term capital gains rates (or use the QSBC exclusion) by selling stock.
The Pass-Through Entity Can Be Used To:
Protect assets from lawsuits by using a limited partnership or LLC.
Produce investment income that is not subject to social security tax by (1) lending money, (2) leasing assets on a net lease basis, or (3) licensing a trade name or technological processes to the operating C-Corporation.
Be a vehicle for making lifetime gifts to family members at a discounted value.
Avoid probate and provide for an orderly transition of property at death.
There are many reasons to use two different corporations in your businesses. These are just the most popular.