As the tax busy season approaches and we prepare our returns, it’s a good time to review some concepts so let’s break down what it means to have a Holding Company.
Basically, a Holding Company’s function is to hold assets. A good example of a true holding company is a Family Limited Partnership (FLP), or a Family Limited Liability Company (FLLC). These are simple forms of holding companies that just hold assets. The other purpose of an FLP or FLLC is to remove assets from someone’s taxable estate. However, that is a different article for a different day.
A holding company can be used for many purposes. For example, let’s say that you want to remove the assets from your business, to either shelter them from creditors or for tax reasons. You would form a holding company that holds the assets and the operating company would then rent those assets from the holding company. This would separate the liability between the operating company and the holding company and wouldn’t put any assets at risk. The downside is that most states charge a sales tax on the rental of business property — which is honestly “de minimus” compared to the benefits it provides.
Most holding companies are taxed as partnerships because if the assets are being rented, the income or loss is passive in nature anyway. Plus, you would reap the benefits of capital gains tax when the company sells any assets. You can also set these LLCs up with managers that in essence act as the general partners of the LLC without the liability associated with that classification. Then you have several limited partners as members. The members of the LLC are the ones that own the LLC and they can be anyone. However, most often they are family members.
To skirt any gift tax rules, you would form the LLC first with the managers and various members and THEN capitalize the LLC — especially if you are dealing with family members as the limited partners. If you capitalize the LLC before you distribute the membership interests, you could run afoul of the IRS.
A management company, on the other hand, can be used for other things outside of asset protection. A good management company can receive income from the parent company and be taxed as a C-Corporation. As a C-Corporation, a fiscal year can be elected so that you can pay the management company more monies in December if need be.
The best management companies work hand in hand with an S-Corporation. They are created as a safety valve for the S-Corporation’s oppressive flow-thru taxation on a wealthy shareholder.
One thing to keep in mind on all of these companies is the same or related shareholder rules. What you absolutely need to have in place is a contract between the various companies that spells out what the monies are being paid for and each business has to have a separate business purpose.
Additionally, each business that has a related shareholder needs to be on the same method of accounting. The reason is that you could literally take complete advantage of the Tax Code if these related companies were on differing accounting methods.
There are various reasons why you may want to segregate the functions of your client’s different businesses. However, you need to set them up correctly, make them legal, and follow the rules as they pertain to the Internal Revenue Code.