Entity Structures: Parent-Child Arrangement
August 31, 2024
August 31, 2024
There are three basic business entities with various flavors within each general category. Here they are:
There is an additional entity subtype with the “Professional” prefix. Some states require certain professionals, such as doctors, attorneys, accountants and engineers, to be a Professional LLC (the PLLC) or a Professional Corporation (the PC). Since you don’t see too many LLPs these days, you don’t see too many PLLPs either.
Two notables missing from the list. First, sole proprietors are not an entity nor is the variant or close cousin of “Doing Business As” (DBA). If you wake up and want to sell used refrigerators, you can, right now, without any formalized structure. It is not smart, but certainly permissible. At times sole proprietors are interchanged with single-member limited liability companies (SMLLC) since the IRS and most states consider a SMLLC to be a disregarded entity for taxation, and both a sole proprietorship and a SMLLC will end up on Schedule C of your Form 1040. However, they are truly different in several underlying ways.
Also note how an S corporation is not listed. It is not an entity. It is a taxation election under Subchapter S of the Internal Revenue Code. The underlying entity has to be a Corporation or LLC under State statute, and usually it is an LLC (either single-member or multi-member) for the ease of formation including documentation.
Spoiler Alert: In California, it is preferred to create a C corporation or convert to one if you are also electing S Corp taxation because when you pay a reasonable salary to the shareholders, they must pay into California’s State Disability Insurance (SDI) plan. However, corporate officers can opt-out. Unfortunately, LLCs do not have officers; they have managers and members. When making the S Corporation election, the underlying entity does not change and therefore LLCs taxed as an S corporation in California cannot opt-out of SDI. Opting out of California's SDI will save 1.9% of officer reasonable salary, which adds up quickly.
When two individuals from distinct states, such as Minnesota and North Carolina, consider launching a business, they face a decision regarding the state in which to establish their entity. This choice is pivotal because, even if they select one state, there might be an obligation to register in the other due to foreign filing stipulations.
States have stringent guidelines about the principle of nexus, which dictates how income is divided among states. Nexus can be activated in two main ways:
There are three primary determinants for establishing nexus:
The Wayfair ruling, although centered on sales tax nexus, emphasized that substantial economic operations could equate to having a physical footprint in a state.
Nexus Explained: To better comprehend the nexus concept, one can draw parallels to DUI regulations. Even if an individual's blood alcohol level is beneath the legal benchmark, they might still be deemed intoxicated based on other criteria. However, once this benchmark is surpassed, the presumption becomes unequivocal. Similarly, states might argue for nexus even if certain criteria aren't met, but exceeding specific benchmarks leaves no room for contention.
Foreign Qualification: This term doesn't relate to global business operations. If a business has operations in another state, be it through sales, workforce, or property, it's mandated to register as a foreign entity in that state. This is typically a procedural norm. However, some states might require the business to maintain good standing with its domicile state. An alternative approach to consider is the creation of a separate LLC in the operational state, which can offer a layer of liability protection.
Holding and Operating Companies: This dual-entity framework offers a strategic edge in terms of ownership delineation. For instance, if you jointly own a property with a relative, this framework ensures they don't inadvertently acquire a stake in your primary business venture and vice versa. It's crucial to recognize that rental properties, even those labeled as self-rentals, are primarily mechanisms for wealth growth rather than immediate tax-saving tools. However, the division between a holding company and its operational counterpart can lead to potential reductions in self-employment or payroll taxes under specific circumstances.
Parent-Child Framework: In situations where multiple distinct business entities need to be amalgamated under a single umbrella, this structure is beneficial. For instance, one entity might operate in the real estate sector, and another might offer IT consultancy (see example below). A primary entity, such as "Smith Ventures," can be conceptualized to be the exclusive owner of both the realtor and IT consultant entities. In this hierarchical framework, both the subsidiary entities recognize the primary entity as their sole owner.
Selecting the Optimal State for Business: For emerging entrepreneurs and small business proprietors, states known for their business-friendly regulations, like Nevada, can be enticing. However, it's vital to be aware of potential legal complexities. For instance, if a business incorporated in Nevada demonstrates negligence in its Colorado operations, the legal proceedings will likely be initiated in Colorado, negating the strategic advantage of Nevada incorporation. Therefore, exhaustive due diligence and thorough research are essential before finalizing a state for incorporation.
Charging Orders: In turbulent financial periods, when creditors are seeking assets, owning a multi-member LLC can offer a degree of protection. In such scenarios, courts possess the authority to issue a Charging Order. This legal tool allows the creditor to claim any distributions from the LLC, but crucially, without granting them any managerial or operational rights within the LLC.
You might have two distinct businesses and you want to combine them under one entity, but they are very different operationally and by industry. For instance, you might own a real estate brokerage and an IT consulting firm. The “Parent-Child Structure” is a potential arrangement to implement in such a case. The “Parent-Child Structure” involves forming a holding entity (a limited liability company), named Brown Family Enterprises, LLC, which holds 100% interest in both the real estate brokerage and the IT consulting firm — the two separate LLCs under the umbrella of Brown Family Enterprises, LLC.
Brown Family Enterprises, LLC can elect to be taxed as an S Corporation; all income and expense activities from the real estate brokerage business and the IT consulting business would be combined and reported on the S Corporation income tax return; the taxable from the S Corporation passed down to the individual shareholder(s) via Form K-1S. Some states would still require the separate LLCs to file informational returns reporting gross receipts, expenses, and demographic information, but that’s generally cheaper and an easier lift that having to administer two separate S Corporations.
Now, you might have pondered question exactly… "Why not operate two separate S Corporations?" That's a possibility, and in some scenarios, it's even necessary (usually in professional services regulated by State professional regulations). However, the added costs related to tax compliance and managing two separate payrolls for the owners is typically sufficient reason to implement the “Parent-Child” entity structure. Using the structure discussed above, payroll for all shareholders is managed by one entity: Brown Family Enterprises, LLC, and since each single-owner LLC is a pass-through entity, you only need one tax return at the S Corporation level.
Here is an example: Based on our experience in the Southern California market, preparing an S Corporation tax return costs between$1,500 and $6,000 (depending on complexity); shareholder payroll services cost between $500 to $800 annually per entity; precise bookkeeping would start at $4,000per year per entity. Let’s assume a total annual cost per S Corporation of $6,500($2,000 + $500 + $4,000). You can either pay $6,500 for one S Corporation with two operating LLCs below it or pay $13,000 to have two S Corporations and end up with the same tax implication.
Another advantage of the holding structure is the flexibility to divest or expand ownership in one business unit without impacting the entire entity. However, there are minor challenges. Every business should maintain its finances separately. General overheads like insurance or tax-related expenses should be borne by the S Corporation, while unit-specific expenses, say website costs, are taken care of by the respective LLCs. Also, if you aim to extract profits from one LLC, it would first go to the S Corporation before being distributed to the individual shareholder. Further, each unit might face substantial annual state fees, like franchise taxes. For instance, in California, you could be paying a minimum fee multiplied by the number of entities. Weigh the pros and cons thoroughly. This strategy is often favored by couples operating distinct businesses but looking to leverage S Corporation benefits.
Note: It is crucial to assess potential restrictions in each LLC. For instance, an LLC that is considered a hobby cannot be shielded under an S Corporation. The aim should be clear profit generation. Additionally, tax nuances, like Section 199A Qualified Business Income Deduction, can differ if one LLC qualifies as a Specialized Service Trade or Business (SSTB) and another does not. Lastly, realize that this article only discusses some of the tax benefits and disadvantages of a Parent-Child Structure. Consult with a corporate attorney to ensure legal concepts are also addressed.
Ownership Expansion: Let's hypothesize you own a property inspection enterprise and another in property renovations. Under the holding company model, you could introduce a partner to the renovation business. This would convert it into a multi-member LLC. Tax filings would involve a Form 1120S for your wholly-owned S Corp and a Form 1065for the multi-member LLC. Another Angle: Each single-owner LLC could be individually owned by spouses. Then, these LLCs could compensate the S Corporation for services, typically referred to as “management fees”. This strategy can be favorable for varied 401k plans across businesses, especially if spouses do not actively participate in each other’s enterprises. Further details on this will be discussed later or you can contact us by visiting the Cruncher Accounting, PC website and scheduling a call.
Disclaimer: The information presented on this website or any Cruncher Accounting, PC online platform is for general information and illustrative purposes only. It should not be considered tax, legal, financial, or other professional advice. The content is not intended to provide definitive answers or solutions to specific business situations and is not a substitute for careful research or the advice of a licensed professional that knows your unique circumstances.
Readers are advised not to rely solely on Cruncher Accounting materials or use them as the basis for any business, legal, tax, or accounting decision without first seeking independent subject matter expertise and counsel. All case studies shown are hypothetical and intended for demonstration purposes only; results shown are not guarantees of performance or outcomes.
Please contact a Cruncher Accounting professional directly to discuss your specific questions or business situation. Our team would be happy to speak with you about a tailored consultation to your needs. We also encourage all readers to seek counsel from licensed attorneys, financial advisors, CPAs, Enrolled Agents, or other qualified professionals prior to making decisions related to their finances or enterprises.
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