By Jason Watson, CPA
Posted Sunday, December 29, 2024

Since this chapter is about unique or custom entity structures, there’s no better place to talk about self-directed IRAs. What the heck is a self-directed IRA? Just because you make investment choices within your retirement accounts, does not mean they are self-directed. Sure, in a practical sense they are. But a self-directed IRA in the context of this section is about a very specific investment vehicle.

Why would you consider this option? Let’s assume that you want to invest into rental properties (which is a great augmenting retirement strategy by the way… we are huge fans), but all your money is tied up in an IRA. You are 50 years old and can’t touch it without penalty. The bank won’t let you borrow against it. You might be hosed.

However, if you set up a self-directed IRA and roll your existing IRA into it, you can have the IRA invest into the rental property. But there is another reason why this might make sense. The S&P 500 index since inception has returned 9.22%. Not bad. Yet in some situations, rental properties might beat or in some cases, crush, the returns of the stock market. And it creates some diversification within your financial planning.

The other option with a self-directed IRA is to start or purchase a new business. A new business might need cash to invest into equipment, franchise fee, marketing, operational cash, etc.

If you want to expand your horizons into real estate notes, equipment leasing, livestock, private debt and equity placements, and oil and gas you can also use a self-directed IRA. Be careful here. Suitability might be your biggest hurdle. Talk to your financial team before squandering your life savings on ocean front property in Arizona.

A 401k may be used as well but it is slightly more complicated. At times you might hear the term ROBS (rollover business startup) plan. Here is a blurb from the IRS website-

A ROBS transaction therefore takes the form of the following sequential steps:

An individual establishes a shell corporation sponsoring an associated and purportedly qualified retirement plan.

The plan document provides that all participants may invest the entirety of their account balances in employer stock.

The individual becomes the only employee of the shell corporation and the only participant in the plan. Note that at this point, there is still no ownership or shareholder equity interest.

The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created qualified plan.

The sole participant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.

The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise.

After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment option. Future employees and plan participants will not be entitled to invest in employer stock.

A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to promoter.

The IRS is also quick to point out that self-directed IRAs and 401k plans including ROBS face a lot of compliance concerns and are generally very risky. The funded businesses also have a high failure rate.

These steps all seem straightforward. What’s the catch? There’s always a catch. Here are the things to look out for.

No S Corps or Partnerships

The way these entities are structured, business profits are returned to the shareholders. Profits cannot fall into the hands of the IRA account owner or 401k plan participant (you). Tainting of retirement dollars is the big thing here.

Prohibited Transactions

The business cannot invest directly in collectibles, art, rugs, antiques, metals other than gold, silver and palladium bullion, gems, stamps, coins (except certain U.S.-minted coins), alcoholic beverages, and a few other tangible items related to personal property. Ok- there goes half your list for sure. Yup, cross palladium off your list.

In addition, friends, business associates and siblings may invest in the business via a self-directed IRA or 401k plan, but your parents, children or spouse may not. The strict arms-length perspective of the business dealings must be maintained.

Key Employee / Investor

You cannot be the key employee and key investor in the business. Nor can you own a controlling interest in the business. Basically, someone else must have the right to hire or fire you such as a Board of Directors. The “someone else” is the grey area in all of this and warrants more discussion.

Having said all this we must fully disclose that WCG CPAs & Advisors are not experts. While we could be, we choose not to and leave a ton of room for exceptions and other workarounds to these rules. There are several wealth and trust advisor firms who do this work all day every day, and are full of competent people. We have worked with Equity Trust and New Direction Trust in the past, and also use KKOS Lawyers.

As you work through all this, the net-net is that the IRS does not allow you personally to receive money that was slated for retirement (at least without penalty until you are 59.5 years old).

To reiterate, a self-directed IRA or 401k is very cool. It allows you to move money you normally could not use into an account that can now be used to get yourself into a rental or a hot franchise. All without having to find cash elsewhere.

Not to throw a big wet blanket on your dreams, but we also see a high failure rate. It is a combination of many things; business ownership is tough. Period. But! There is also a feeling generated from using your IRA or 401k funds where the money doesn’t seem real… like it is Monopoly money or something. Regardless of where your money is coming from, your business always needs a solid plan, a budget and a little bit of good fortune.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

If you are financially in trouble, and a creditor wants to take your assets, your multi-member LLC and its assets might be safe. Instead of taking the LLC directly, a court can issue a Charging Order which allows the creditor to receive any distributions from the LLC. The theory is quite simple- if you are in business with another person, and that person has financial trouble, why should it be your problem? Your only problem should be where to send the profit distribution check for that person’s distributive share.

A Charging Order puts the creditor in line for any financial rights that the debtor has, but does not convey any management rights. Therefor the creditor cannot order the LLC to make a distribution. However, many states have allowed the creditor holding the Charging Order to foreclose on the membership interest of the debtor. Yuck. This is done under the auspice that the debtor will not be able to re-pay his obligation. So now the creditor is the permanent owner of the financial rights of the debtor’s portion of the LLC, but the creditor still does not own any member interest in the LLC. This results in the debtor owning a portion of an LLC that he will never receive any money from since his financial rights are now in the hands of the creditor.

It doesn’t stop there. Some states and certain courts can also assign the full interest (ownership and financial, or some would say equity and economic) to the creditor. This creates a big mess for the other members of the LLC who suddenly need to scrape up enough money to pay off the creditor so as to not be tethered to them as a co-owner.

What does all this mean? Some attorneys want to automatically add a spouse to the LLC so it suddenly becomes a multi-member LLC with the financial protection of a Charging Order. Sure, why not? There is some protection there with very little effort.

As a side note, here is Delaware’s verbiage about Charging Orders under Title 6, Section 18-703–

Makes you want to run out and form your LLC in Delaware doesn’t it? Again, if you are marching into court with a boatload of financial woes and hanging your hat on Charging Orders for your financial protection, you might have bigger problems. Creditors are wise to this, and they usually make you personally guarantee the financial obligation as an individual.

Also, if you form an LLC in Delaware and operate in Colorado, you will need to file as a foreign entity in Colorado. If you receive process of service in Colorado for a lawsuit, you are now asking a Colorado court to interpret and enforce Delaware law in your matter. Courts and judges are not fond of this ask. We keep mentioning this concept is several spots just to drive it home (and because small business owners jump into our book at various spots).

By Jason Watson, CPA
Posted Sunday, December 29, 2024

Can you be sued personally if you operate an LLC? Yes. And you can easily lose on both a business and personal level. There are several myths out there regarding the use of an LLC as a shelter from potential lawsuits and litigation. Some of the hype has been created by attorneys who used to charge upwards of $1,000 to form an LLC. Need to pay for condos in Maui, presumably. We accountants tease attorneys that LLC really means Lawyer’s Likely Choice.

Sidebar: LLCs are quite powerful. As we’ve already discussed, the deal structures within the entity are endless and the flexibility is strong within multi-entity arrangements. Let’s not forget solid estate planning can be achieved with an LLC as well.

Back to picking on attorneys. Remember, attorneys are not necessarily smart because they went to law school. People are smart, and smart attorneys are people who were already smart and then chose law as a profession. To be fair, the same is true for accountants and doctors.

While consultation with an experienced attorney is strongly recommended for your unique situation, as business owners ourselves we feel the excitement of the LLC has overshadowed the reality of our litigious society. In other words, if your acts, errors or omissions injure someone even though it was under the auspice of your LLC, there is a good chance you will be personally named in the lawsuit and held liable as the owner of the LLC.

The word liability in the LLC truly refers to financial liability. Please read on.

For the matter of this liability discussion, LLCs, S Corps, C Corps and limited partnerships are considered the same. No liability protection is asserted for sole proprietorships, general partnerships and general partners in limited liability partnerships (don’t forget the old timer LLLP which limits everyone’s liability even the general partner). Sure, this is a huge generality, and exceptions always exist depending on agreements and state law.

Types of Liability

There are three areas where you can be held personally responsible- criminal, contractual and torts. Torts is probably most people’s concern, and torts can either be-

• negligence where you have a general duty to act in a reasonable way and you didn’t (like drive your car safely), or

• intentional torts where there was a purposeful act to harm.

There are other tort buzzwords like gross negligence, careless disregard, defamation, etc. Remember, negligence is the opposite of diligence.

Piercing the Corporate Veil

Officers and directors of corporations are routinely held liable for the actions of the corporation. This is called piercing the corporate veil. Can you say Enron?

Piercing the corporate veil typically is most effective with smaller privately held business entities (close corporations) in which the corporation has-

• a small number of shareholders (owners),

• limited assets, and

• separating the corporation from its shareholders would promote fraud or an inequitable result.

While this is referring to a corporation, the same philosophy is applicable to a limited liability company. Does that sound like your LLC? Yes. Could it happen to you? Yes. Is there a small chance of this happening? Who knows? We say risk it, put it all on red and let it ride. Just kidding. No one bets on red.

Even a two-member LLC would easily be considered a closely held entity. If those members were grossly negligent in the way they managed the business, separating the corporation from its shareholders (or LLC from its members) would certainly promote unfairness from a liability perspective. This is our opinion of course, but we want to share with you some of the behind-the-scenes perspectives from the courts and law that might not be readily considered when forming an LLC.

Another perspective- if you owned shares of Ford Motor Company, you were not personally responsible for the damage caused by the Ford Pinto even if you were a shareholder. However, if you were a corporate officer who ignored (gross negligence) the potential for harm, you could be held responsible, even criminally. In other words, fix that loose railing before your tenant hurts himself (using an LLC owning a rental as an example).

The general rule across the country is that individuals acting on behalf of a business are personally liable for their tortious conduct even if they did so on behalf of the business. So, to protect your personal assets you need to fund the LLC with enough resources to pay for a lawsuit. This defeats the purpose of not having to pay personally since you are personally doing the funding.

There might be situations where an investor has a lot to lose personally as compared to his or her smaller co-investors. Therefore, perhaps funding the LLC on an equal basis to hedge against potential lawsuits or to have similar language in an Operating Agreement or Partnership Agreement can mitigate some exposures.

Furthermore, if you own multiple investments and LLCs, and you think you can protect the other assets in the event of a lawsuit on one, think again. In our non-legal opinion and observation of surrounding events, if you face a credible lawsuit arising out of your acts or omissions there is a chance everything you have is going to be pursued by the injured party’s attorney including your personal residence, cars, college funds, LLC’s assets, Snuggie collection, etc. Yes, even the leopard one.

Other Things to Think About

You are a reasonable person. Does it seem reasonable for someone to hide behind the auspice of an LLC or a corporation when they do bad things? Of course not. Public policy shouldn’t allow this. Therefore, it follows that if you maintain an unsafe rental property or if you are reckless while driving the business car, you should be sued, and you should lose.

Some attorneys will argue that if you mix personal and business funds together, even accidentally, you might erode the separation of you, an individual, and the business. For example, a business owner will pay for car insurance through the business. The car is owned personally by the business owner, and the owner is getting reimbursed for mileage. On the books, the car insurance is not a deductible business expense, and is coded as an owner draw or shareholder distribution. In this scenario, a court might determine that the “veil” between you and the business is getting thin, and might be determined to be too thin.

Same with minutes and other business governance. Some argue that if you do not keep up with the housekeeping of your business, you can chip away at the corporate or LLC protection. There is a natural human response to pile on once a defect is discovered. “In closing your honor, on top of Exhibits A through AJ, this LLC failed to record basic business governance.” While we doubt how much weight this would be given, it certainly helps buttress a level of carelessness or disregard. As mentioned elsewhere, LLCs generally do not document meetings or minutes unless the state requires it.

Protecting Yourself

After all the gloom and doom, there are some small elements of protection. If your employee’s conduct creates a liability for himself and one for the LLC, the owner of the LLC may be absolved. This can get tricky depending on the conduct, and any instructions the LLC provided to the employee. This is attorney type stuff.

So, what do you do? In addition to your general business liability insurance, you should secure a decent umbrella policy both at the personal and commercial level. This is our strong recommendation for liability arising from your acts, errors and omissions. General umbrella policies are $1,200 to $2,000 per year depending on the limits. Something to note is that your liability limits on the underlying assets such as buildings, rental properties and cars might have to increase to reach the floor (starting point) of the umbrella policy. This prevents gaps in insurance.

Errors and omissions insurance varies depending on your profession (realtor versus financial advisor versus insurance sales).

It appears that many credible lawsuits will sue to the limit of coverage to avoid lengthy and expensive trial litigation. Again, please consult your attorney and insurance agent for your unique situation.

LLC Protection in Borrowing

In addition to the above, there is also a small element of financial protection. LLCs and corporations protect the owners from being personally responsible for the business’s debts and obligations unless the owners or officers personally sign for the loan (called a recourse loan).

However, in today’s lending climate it will be very difficult to get a business loan in the name of the LLC without having to sign a personal guarantee on the note. In other words, you will more than likely need to sign twice- first, as the person directing the business to borrow and second as an individual promising to pay should the business fail to do so.

Business debt without a personal guarantee is called a non-recourse loan since the bank or lender does not have a recourse against the individual. Tough to get, expensive at times and requires significant equity (60% loan-to-value is the general rule of thumb using real estate as an example).

Quick Recap: In personal worlds including small businesses, loans are typically collateralized twice. First, property is attached with a lien so you cannot sell it without paying the lender. Second, your promise to pay. Lenders can sue to foreclose on the property, and they can also sue based on your now-broken promise to pay.

How this works is straightforward. Let’s say you own three businesses, one is an LLC operating a pizza joint, another LLC owns a rental with a ton of equity, and another LLC is used to trade stocks, bonds and options. The rental was purchased with a non-recourse loan. The rental house has extensive mold, is un-insured for mold, and eventually is foreclosed leaving some creditors holding the bag. Picture the poor guy in Monopoly. Those creditors cannot attach or seize your pizza joint or your portfolio since they are held in other LLCs. This is an overly simplified example, and there are probably some rare and narrow instances where you could still be in trouble, but generally this strategy affords some protection according to most attorneys.

A common arrangement is the self-rental which is discussed in more detail later, but here’s a glimmer. You operate an LLC as a business and you also buy the office building with another LLC, of course with a non-recourse loan (the only collateral is the building itself and not your personal promise to pay). The business also has a line of credit. Depending how all the debt is structured, each of these assets (the business and the building) has a Chinese Wall between them. Don’t laugh; that wall served well for nearly 3,000 years.

Again, banks are smart. You are not the first Tom, Dick or Harry to come around. We should probably update the names to reflect the current smattering- how about you’re not the first Parker, Logan or Dakota to come around with your androgynous name and lofty schemes. Most lenders require personal guarantees on every loan.

Asset Protection in Equity Stripping

Another asset protection strategy that is older than dirt is equity stripping (it does not necessarily need an LLC either). It is a process of encumbering your assets to the point where there is no value for lack of equity. In the simplest of forms, you pull cash out against your assets, and separate your cash from the assets. Be very careful. There are “bogus friendly lien” triggers where a person will use a Nevada corporation to file a lien against the asset, however the asset and corporation are owned by the same person (or some related party). This lien is subsequently pierced or tossed as self-serving or deemed to lack commercial merit.

Equity stripping can be a good asset protection strategy, but it requires careful planning with a skilled attorney. And No, it is not older than dirt but it has been around for quite some time.

LLC Protection in Contracts

There is some wiggle room on financial shielding using a limited liability company. If you sign a contract for internet service, or for a copier lease, or some other commitment, you might be able to get away with executing the agreement under the LLC. So, if your business or real estate investment fails, the LLC might be liable for the remaining contract obligation but not you personally.

Keep in mind, however, the judgement and foreclosure process could still get you- if someone gets a judgement against the LLC, they can later attempt to foreclose on the distributions or future income of the LLC, and they can also later foreclose on the equity (ownership) of the LLC. On top of all that, your business bank account might be seized to the amount of the lien.

How about we just keep our promises and pay our bills, huh?

Liability and State Nexus

We’ll chat about nexus from an income tax perspective in the next few pages- this little tidbit is about nexus from a liability perspective. Several business entities are created in what some people perceive as business friendly states, such as Delaware or Nevada. But when it comes to liability especially tort liability, you will generally be sued in a jurisdiction where you have an economic and / or physical presence.

Yes, an attorney will show up and attempt to fight jurisdiction. But he or she might lose. Now you must hire an out-of-state attorney to fight your out of state lawsuit. Sounds like a grand plan.

So, if you file Articles of Formation, Organization or Incorporation in another state such as Delaware, maintain a presence in Kansas and cause damages in Kansas, you will probably be sued in Kansas. Yes, you can write contracts that clearly dictate the forum of law, but now you are asking a Kansas court to possibly understand and enforce Delaware law. According to several attorneys that we work with, if you march into court pinning your hopes on Delaware law being enforced by a Kansas court, you have already lost. Mediate, settle and move on down the line.

Also, most parties will want the jurisdiction to be in their backyard. You trip and fall in a Wal-Mart and sue Wal-Mart, you are not having to fly to Bentonville, Arkansas to file the lawsuit. Although Table Rock Lake to the north of Bentonville is amazing, you want to sue in your local town, using local courts and jurors. After your big fat judgement, fly to Table Rock Lake in your private jet. Good stuff!

If you have a presence in all 50 states, using Wal-Mart as an example again, you have to pick a state to call home regardless (your domicile), and then file as a foreign entity in all the other states. Picking a more business friendly state makes sense if your operations span several states. Attorneys call this forum shopping. This can be leveraged when you are a large business who enters into several contracts per year, and your attorneys are exceptionally crafty and completely (and only) understand a certain state’s laws.

For 99% of the small business owners out there, keep it simple- organize in your home state. You truly have only two major concerns. Where contract disputes will be argued, and that can be dictated within the contract. The other concern is tort liability, and that is usually mitigated with insurance and being a diligent human being.

Yet another example. A lot of real estate investors will incorporate in Nevada (for example) because of the seemingly friendly business laws, and then buy rental properties in Colorado. This requires a foreign entity registration in Colorado. It is a near guarantee that if you are grossly negligent in the maintenance of your rental, you will be sued in Colorado. So why the heck are we forming in Nevada? Or Wyoming? Or Delaware? The theory is that a Colorado court would then interpret and enforce the other state’s law in your lawsuit. Good luck with that.

Please don’t believe the hype. Do your homework! Do you know of anyone in all your walks of life and circles that fought a lawsuit based on some other state’s law? Perhaps, but sleeping at night solely based on this layer of protection might not be that comforting.

There are some situations such as several remote principals collaborating on a business where the “home state” becomes murky. For example, WCG has a client where three brothers own a hotel in a Caribbean country. We formed a Florida LLC since two brothers were residing in the foreign country and the third was residing in New York.

We have another client where the three principals lived in Oregon, Texas and New Jersey. We formed the entity in Wyoming and filed as a foreign entity in each state.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

Nothing lasts forever, even the Cubs eventually won a pennant. If your business partner is not your spouse, understand that you could suddenly find yourself in business with his or her spouse or children. Imagine you and your partner. Happy as a clam. Successful. Cement truck. Dead. She left everything she owned to her whacked out children including her portion of the business. Now you and her kids are partners. Wonderful. Do scenes from Horrible Bosses come to mind?

But valuation and funding are the biggest hurdles. For example, the business might be worth a zillion dollars, but has no cash. Or the value is all tied up in assets, such as houses, buildings or machinery. Exit plans or Buy-Sell Agreements really make sense only when the business has value.

In many cases, especially specified service trades or business such as accountants, financial advisors, etc., the remaining partner or partners can simply start up a new business in a different name, and carry on as usual. Huh? Example time. Let’s say you and your partner are accountants. Living the high life, declining Robin Roberts interviews, driving fancy cars, etc. One day you decide to call it quits. In this situation, both partners could simply split the office equipment and break away with his or her book of the business and move on as individuals.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

If you are a single-member LLC or if your business partner is your spouse, this information might not apply. But if you are in business with another person, even a brother or sister-in-law, then a beefy Operating Agreement is a must have, at least eventually.

Operating Agreements are like Bylaws for an LLC, and they protect the rights of the members and define the parameters in which the members can operate. In general, attorneys do an adequate job drafting this critical document, but there are some holes that WCG CPAs & Advisors feels compelled to mention.

Death, Divorce, Incapacitation

Death and divorce are easy, and attorneys have this in their templates all the time however incapacitation is often left out, or only briefly mentioned. Look at the recent Donald Sterling who was found mentally unsound and could not run his business. If your business partner is Donald Sterling who is not dead nor divorced much to Clipper fans’ chagrin, you might want a contractually obligated and legally enforceable plan to get rid of his member interest.

Do you need one doctor? Two doctors? What is the triggering threshold? Traumatic brain injuries are more common than you think and therefore you need to protect yourself if they occur. It is not just incapacity from a mental perspective either; your business might suffer if a member cannot physically perform the role either.

Accounting, Corporate Waste

Most attorneys draft language allowing any member to request a formal accounting of the expenditures and financial records, and this is commonly afforded in most state statutes that govern corporations and LLCs. However, they often neglect to build thresholds where all members must sign off on an expense. For example, let’s say you are a minority member at 25%, and the other three members are also 25% each. Interestingly, the other three members are also a voting block since they are all family members as well. What’s to prevent them from buying a business car for someone other than you?

In Colorado we have seen a flood of marijuana investors. This is a cash business of course and all these minority investors are pouring their savings into new pot farms. It is not a bad investment; first to market, stake your claim, build mega farms, control the pricing, etc. However, and this is a big however, it is still a cash business. Don’t you want a little assurance that the majority owner is not skimming the till?

Did you know the IRS can determine your sales volume as a bar owner? They look at your purchases which is why most bars must buy from a distributor. Determine the cost of goods purchased slap on a regional markup, and boom, you have sales regardless of what the cash deposits say. Same with divorces; we often look at lifestyle and spending to “back into” the income figures.

There are several other examples that fall under the accounting and corporate waste provisions but we need to move along.

Distributions

Oftentimes the business will have income, but no cash since it is re-investing back into the business. However, as a shareholder of an S corporation or a member of a garden variety multi-member LLC, you will pay taxes on business income (profits) and not distributions. Theoretically you could have a big tax bill based on income but never see the cash. How does this work?

The business has net income of $100,000 after expenses and everyone decides to put the money back into the business such as inventory purchases. Cool, since everyone agrees but all the owners will have a tax obligation based on the $100,000 (inventory purchases may immediately reduce net income but there are rules, so please play along for now). This means that if you are a 25% owner at a 22% marginal tax rate, you will have a cash out-of-pocket tax bill of $25,000 x 22% or $5,500.

WCG CPAs & Advisors recommends two things when it comes to distributions. First, define and calculate working capital for your business. If the entity needs working capital to operate or for future purchases or initiatives (what we call capital expenditures or capex for short), how is that calculated? Second, once working capital is defined, what portion is distributed and what is kept in the business?

Let’s run through an example of working capital. Let’s say your law firm specializes in personal injury and as such your revenue is lumpy. To be safe, you and the other partners determine that you need 6 months’ worth of expenses in working capital. Also, the law firm is moving next year into a new office which needs a build-out. You add that up and excess cash is available for distribution.

Sidebar: When you grow working capital, you will have a tax consequence. For example, if you want to increase from $100,000 to $200,000 in working capital next year, you will pay taxes at your tax rate (assuming a pass-through entity such as a partnership or S Corp). As you might know or will soon learn, as an S corporation shareholder or partner in a partnership, you are taxed on the profits earned by the business whether you distribute the earnings or retain them for future bills. Therefore, at a 22% marginal tax rate, your $100,000 growth in working capital will take $22,000 in taxes. The good news if you reduce working capital, that distributable cash is tax-free.

From there, the Operating Agreement could dictate that a minimum of 40% is distributed to the owners unless all owners agree to a different figure. This helps reduce some of the tax sting of net ordinary business income after expenses and deductions being allocated to you without the same amount in cash.

What WCG recommends is-

• Determine working capital (time-based operating expenses + capex + buffer).
• Determine a budget.
• Use math to then determine how much you can safely distribute to the owners.
• True up each quarter or semi-annually to align reality with budget. In other words, if your interim profit is higher than budgeted, perhaps another off-cycle distribution can safely occur.

Another common example is when you are the minority shareholder or member. The majority elects to increase wages for themselves and not pay distributions, basically starving you out. My partner would never do that! Really? Ok. But everyone else not living in fantasy land, an Operating Agreement can protect from this situation.

Dispute Resolution

Templated Operating Agreements usually have language about dispute resolution, and specifically mediation. Mediation is fine, and some courts have a standing order that parties will attend mediation prior to trial. However, mediation is not binding and parties don’t necessarily have to enter into mediation with good faith. Trials take a long time- anywhere from 12 to 24 months, just to get to opening statements.

Arbitration is like mini-court and the rules of discovery and evidence are usually more relaxed including procedure. They can be expensive since you are paying for your attorney plus the arbiter who is usually a retired judge or attorney. However, they can also be efficient.

Regardless of mediation, arbitration or trial, make sure your Operating Agreement has expeditious dispute resolution provisions, and incentives for all parties to be efficient and bargain in good faith.

Business Valuation

If a member wants out, no problem, but what is the value of the business? Should you use a formula to determine the value? Perhaps something based on revenue? A full-blown business valuation (our retainer is $3,000 for a conclusion of value business valuation engagement)? What if you and your business partners cannot agree on the selection of the business valuation expert? Make sure there are provisions in your Operating Agreement.

As a side note, if the value cannot easily be derived from a formula, we often see language where the exiting member and the remaining members each pick a business valuation expert. Then those two experts pick a third as a neutral, or some other seemingly detached and disinterested selection mechanism.

As we’ve said in the past, just because you are working with an attorney or an accountant doesn’t mean you are working with a smart person. WCG CPAs & Advisors can act as a consultant with your attorney when drafting these documents.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

While discussion with a qualified estate planning attorney is essential when using a Trust, here are some basics about Trusts to better understand how they mesh with your business world.

Trusts do two things very well. First, they usually help bypass probate. If you own property in three different states, then probate must be opened and closed in all states. The process is long. It is expensive. It is public.

Second, they help you, the dead guy, dictate policy from the grave. If you want to ruin a 30-year old’s life, give Junior a million dollars. A Trust can dole out money according to a schedule. Special needs kid? Drug addict? Nut-job son-in-law? A Trust can protect your interests long after you’re cold.

Trusts might also protect your children. Here’s an example. You die. Your wife wears a short dress and heels to the funeral, and waits the obligatory 4-6 weeks before dating again. She gets married because your dying words were, “I want you to be happy.” She lives another decade and then dies suddenly. Now this dude whom you never met has all the money and doesn’t care about your kids. Wonderful.

The only difference for women is that men would only wait 2-3 weeks to start dating, but the rest remains unchanged.

Revocable Trusts are also called Living Trusts. This is where the grantor and the trustee can be the same person. If a revocable trust owns real estate, the grantor can burn the place down, paint it purple or sell it. Since the grantor has ultimate authority over the trust asset, there is no creditor or asset protection afforded. Zippo. None. Don’t believe the asset protection hype. If you want protection, you must usually give up control.

Irrevocable Trusts are the roach motel- assets can check in, but they can’t check out. The grantor does not have any authority over the trust; only the trustee does. The trustee cannot be you, the grantor. The trustee could be your best friend but cannot be influenced by you. The trustee must make decisions with the Trust’s interests in mind as a fiduciary.

Some people try to install poison pills in an Irrevocable Trust where if certain events happen, the assets revert back to the grantor. Be careful on this. The IRS detailed in Private Letter Ruling 201426014 that the,

provision in trust that provides that, in the event that both the children are no longer serving as members of the Distribution Committee or if there are fewer than two serving members, the trust property will be distributed to the grantor, and the trust shall terminate, constitutes a reversionary interest under Code Sec. 673.

This is one example of a poison pill that backfired. This was a Revocable / Living Trust disguised as Irrevocable.

Those items that have built in beneficiaries such as life insurance and investment accounts might be placed in a Trust, but they do not have to be since these assets bypass probate automagically. However, if you want these proceeds metered out according to a schedule, then the Trust needs to be the beneficiary. Get some planning!

Litigious assets are usually encapsulated in an LLC prior to being placed in a Trust. Automobiles are an example of litigious assets, but they are usually directly owned by an individual. Real property such as rental real estate is another great example. But what if you wanted to have your rentals pass through to your estate and skip probate?

Several estate planning attorneys recommend the following arrangement-

Having said all this, many business and corporate law attorneys will suggest only using an LLC with an Operating Agreement, and not rely on a Trust. The new generation of estate planning attorneys are also abandoning the use of Trusts. Some believe that Trusts are being oversold, and while they are necessary, the ideal situations are fewer and farther between.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

We broached this from an investor perspective earlier and is largely repetitive. This tiny section expands on the notion of your cash going into the business, and how that might be problematic.

The question comes up from time to time about how to fund the new venture. If you are the only owner, then any money going into the business should be deemed a capital injection and not a loan. For some reason small business owners want their business to owe them money; this typically does not make sense and can set you up for problems down the road.

For example, if you lend your business money and it goes bankrupt, your bad debt deduction might be limited as a short-term capital loss. According to IRS Publication 535, a business loan is comprised of-

• Loans to clients, suppliers, distributors, and employees

• Credit sales to customers, or

• Business loan guarantees

As such the loan to your business might be deemed a non-business loan and limited as a short-term capital loss.

Let’s not forget that you must also impute interest expense to the business, and then subsequently pick up interest income on your individual tax return (Form 1040). Issuing a 1099-INT from the business to yourself seems silly, but true!

However, another situation might arise where you are partnering with someone else, and let’s assume you have all the money for startup funding. Recall the golden rule where the person with the gold makes the rules. As such, you might want to consider your funding as a loan to the business. This allows you to do two things; you can take money out of the business ahead of others as a loan payment (return of capital) and you can execute a personal guarantee from your other partner collateralizing the loan.

You can also convert your loan into additional equity. For example, you are a 50% owner and lend the business $100,000. Things are going great; however, the business does not have the cash to pay you back since all the cash is being re-invested back into the business. You might have a provision within the loan agreements that allows you to convert the debt into equity.

We talked more about this myriad of possibilities when partnering with others, including adding partners in a previous section. Check it out!

By Jason Watson, CPA
Posted Sunday, December 29, 2024

One of the many challenges facing small business owners is health insurance and out-of-pocket medical bills. Generally speaking, self-employed health insurance premiums, including dental and vision, are directly paid by the business and are deducted as Officer Compensation on a business tax return That’s good. Health Savings Account (HSA) contributions are also directly paid by the business and are deducted as Officer Compensation. More good news!

As we stated elsewhere, these fringe benefits inflate Officer Compensation but are later deducted on the owners’ individual tax returns. We call this an “in and out” since the net change on the individual tax return is zero and the actual deduction takes place on the business tax return. But what about out-of-pocket medical expenses like co-pays, lab fees, prescriptions, etc.?

Health Reimbursement Arrangements (HRA) have been around since the 1960s and became very popular in the 1990s, but they recently went through a transformation as a result of the Affordable Care Act. The 21st Century Cures Act and H.R. 34 established the Qualified Small Employer HRA (QSEHRA, pronounced “Q Sarah” opposite of “Suzie Q”). Beginning in 2017, qualified businesses with fewer than 50 employees who did not offer group health plans could use a QSEHRA to reimburse for health insurance premiums and out-of-pocket medical expenses.

There is a catch! A greater than 2% shareholder of an S corporation cannot participate in a QSEHRA. They can, however, participate in a garden variety Section 105 HRA but still do not enjoy the income tax deduction of HRA reimbursements. Huh? If an S Corp reimburses a shareholder, that amount is added to Box 1 of the W-2 as Officer Compensation just like self-employed health insurance premiums and HSA contributions. The huge difference is that HRA reimbursements are not later deducted on the owners’ individual tax returns as they are with self-employed health insurance premiums and HSA contributions. Instead, they are reported on Schedule A as medical expenses subject to all the usual limitations.

There is still a savings however! As we will reiterate many times throughout the book, self-employed health insurance and HSA contributions can be leveraged into providing a lower yet reasonable S Corp shareholder salary. HRA reimbursements are not allowed for S Corp shareholders (but wait, there’s more).

Let’s assume that data support an $80,000 Officer Compensation as reasonable.

As you can see, we are “building” Officer Compensation by adding wages, health insurance, and HSA components together. How does this help?

Here is a quick table that illustrates how leveraging the non-salary components of Officer Compensation reduces Social Security and Medicare taxes-

Recall that earlier we determined $80,000 was considered a reasonable amount of Officer Compensation (of course, yours will vary). But because of other components, we were able to pay a salary of only $61,000. This $29,000 reduction in salary saved $4,437 in Social Security and Medicare taxes. In the absence of other components, we would have had to pay $80,000 in wages. Yuck.

Back to the HRA. How could we get an income tax deduction using an HRA? Good question. That is where a C corporation comes into play.

A C Corp is not a pass-through entity and therefore it does not have to worry about the greater than 2% shareholder rules that S Corps face. Therefore, a small business owner could set up a C Corp that offers services to an S Corp in a business to business transaction (such as a fee for service agreement), and then pays medical bills on behalf of the C Corp employee(s). The S Corp’s income would naturally be reduced by the fees paid to the C Corp which would have a double benefit; lower income taxes and a possibly reduced shareholder salary.

You would need a business purpose for the C corporation such as providing marketing or management services. To buttress this, you could identify certain expenses to be paid from the C Corp. For example, you would pay for web hosting, SEO services and other marketing expenses from the C corporation, plus the medical expenses.

The savings might be significant. TASC boasts a 20% add-on to your marginal tax rate; this 20% seemingly represents the Social Security, Medicare and state income tax savings added to your federal marginal income tax rate. We don’t necessarily agree since the Social Security and Medicare component is already available with an HRA deployed in a standalone S corporation. But… if we play along… if you spent $10,000 in out-of-pocket medical expenses at a combined marginal tax rate of 30% (24% + 6% for state), then you save $3,000 by using the C corporation entity structure. An additional tax return would be required at around $1,000 in tax preparation fees so you pocket $2,000.

If you have $20,000 in annual medical expenses, then your savings would be $6,000. Those are real dollars.

What about audits? C Corps with under $250,000 in assets have a 0.5% audit rate and S Corps have a 0.4% audit rate. Individual tax returns with a small business are upwards to 2%, and even higher with travel, meals and auto expenses (the low hanging IRS fruit). As a side note, if your C corporation has $20B in assets you audit rate in 2017 was 58%. Luckily most people reading this book are about $20B away from having to worry.

More discussion is required to ensure the C Corp idea fits your objectives, but you can see the basic arrangement.

We are only going to scratch the surface on the types of deals and arrangements that you might see out there. Our intent with this section is to illustrate some of the considerations. One of the common statements we get from clients at WCG is, “I have a guy who is giving me $100,000 to help me start my business.” Our next response is, “Will the guy be an investor, lender or both?” Then your response is stunned silence… which is certainly re-assuring. Not!

There are many ways to handle this, and no one way is always the best. It depends on humans, emotions and personal objectives. Don’t forget the golden rule where the person with the gold makes the rules (you hear this often in our book, but it is so true).

Here are some ideas and various considerations-

Investor is Truly a Lender

If the investor wants to get paid back first with interest then make him or her a bank, and pay or accrue interest accordingly. Done. This is also finite, right? After the loan is paid back, the cord is cut, and everyone lives on like perfect strangers.

Investor is a Lender with Profit Interest

Same as above, but once the loan is paid back the investor continues in an economic interest capacity and has claim to some of the profits. Perhaps this claim expires at a predetermined time such as five years following loan re-payment. This is tricky since the investor is both a lender and an owner of sorts which could be conflicted.

This is commonly called a profits interest where you receive a share of the future profits (revenue less expenses) and the appreciation of the assets of the business. There are some rules, with the most common one being “the service partner must receive only a profits interest in the partnership in exchange for the contribution of services.” In turn, the profits interest partner cannot be given a share of current capital in exchange for the contribution of services. This makes sense since you usually have tax basis in your capital, and to have tax basis you needed to have paid taxes on that capital at some point in the past.

Investor is a Lender with an Interest Upon Sale

Similar to above, but the lender gets a piece of the action upon sale. Perhaps the loan is paid back as necessary, with the sale option enduring into perpetuity. The thought process is, “hey I helped you get off the ground and now you owe me beyond the 8% interest I charged.” Surely these are your inside words and they are presented in a softer way to others.

Some caution is in order too. You might not have any control regarding the sale such as terms, timing, etc. For example, you have an agreement that upon sale you get 10% of the proceeds. Great! What constitutes a sale? What if a 100% owner sells 60% of the business but retains the remaining 40%? Hmmm. In these cases, you could draft the agreement to read that upon sale, partial sale or change in control, there is a payout.

That change in control is a big deal since you probably have a personal connection with the owner, and now you are tethered to someone else. People are pro-marriage, but they generally do not want to be told who to marry.

Back to the original idea. The investor is initially the lender but has a contractual interest should an event occur regardless of the current loan status (paid off or not). These particular arrangements need to be stress tested with various scenarios and contingencies.

Investor is an Owner

Rather than recording a loan on the books, the injected cash is credited to the investor’s capital account. The investor may get a return of capital prior to other owners per an agreement. In other words, distributable cash goes to the investor first as a return of his or her original investment. The splits can vary; for example, the investor contributed $90,000 and you contributed $10,000. You could still own 90% of the entity while the investor only owns 10% (an exact flip-flop). We call this special allocation.

Loans Versus Capital

Most lenders want some sort of guarantee from the owners. As such, the angel investor might demand that you guarantee the loan personally which can make a failed business scenario a messy one such as ruined friendships, awkward Thanksgivings and all that stuff. Conversely, an investor who wants to be an owner (versus a lender) and injects capital now has a seat at the table so-to-speak and might not fully let you run the business the way you see fit.

Your Capital as a Loan

While there might be some good reasons, typically you do not personally lend money to your single-owner business. We hear it all the time, “my business owes me money.” Unlikely. Rather, what is meant is that you’ve invested money into the business and / or perhaps you’ve paid for business things with personal funds (since the business was broke). This is invested capital and not a loan. When there is distributable cash, you can take that capital out of your business generally tax-free.

Keep in mind that a loan requires a loan document, amortization, interest expense (which becomes income to you) among other things. Therefore, while the venture might have your money, it doesn’t technically owe it to you. However, you are allowed to take it back when it’s sitting on a pile of cash.

S Corp Rigidity

As we have explored in other parts of our book, S corporations can be super rigid with the splitting of distributable cash. At times you also want to get a rip of the action ahead of others. In partnerships, not taxed as an S Corp, these “payments ahead of others” are usually in the form of guaranteed payments. You do not have this option in an S Corp unless it is in the form of increased shareholder salaries which largely defeats the purpose of an S corporation election.

What about varying capital accounts in an S Corp situation? Let’s say you and another person are consultants and you ban together to form a 50-50 partnership, and you also want to use the S Corp election to save on self-employment taxes. Furthermore, you have $100,000 to invest and your partner has $1,000 and some average looks. A consideration (not a rule or a must-have) would be to have each of you inject $1,000 in cash as capital, and then you provide the remaining $99,000 to the shiny new S corporation as a loan. This allows for an elegant way for you to get your cash out.

Ineffective S Corp Elections

Limited liability companies are amazingly flexible in structuring a deal. As mentioned elsewhere, you can build an LLC with all kinds of deal structures such as-

• Special allocation of income and losses (including qualified income offsets to maintain compliance),
• Liquidating distributions made in accordance with positive capital account balances,
• Employment agreements,
• Buy-sell and redemption agreements, and
• Options and warrants, including convertible debt.

This list isn’t exhaustive, but what this is telling us is that certain agreements inside and outside the Operating Agreement might make the S Corp election ineffective. Why? Special allocations are simply not allowed in an S Corp. That’s easy. However, the outside agreements such as employment, buy-sell, redemption, options, warrants, debt instruments, etc. (all the fun stuff in this section), can create a second class of stock. As you might recall, an S corporation can only have one class of stock (voting and non-voting is allowed, however) according to Treasury Regulations Section 1.1361-1. Recall? Of course you do!

We talk more about this in a later chapter.

Front-End Back-End

There are two things to consider when bringing in another owner or becoming that new owner yourself. Do you want to make money on the front-end, or the back-end, or both? In other words, do you want to make money along the way as an investor owner getting a return on investment from operations? Or… do you want to forego some money from operations, and put more emphasis on an eventual sale?

Sidebar: You might hear the term liquidity event. According to Investopedia, a liquidity event is an acquisition, merger, initial public offering (IPO), or other action that allows founders and early investors in a business to cash out some or all of their ownership shares or interest.

Of course, your risk aversion and the risk versus reward thing are going to drive this decision including your current lifestyle and income needs. Are you the person who works hard trusting you’ll get paid in the end? Or are you the person who wants money today and is willing to sacrifice the big payday at the end? Everyone is different. Every deal is different. You just need to find one that fits everyone involved.

Venture Capital

As we’ve mentioned here and there, and at the risk of over stating it, the one with the gold makes the rules. This is the Golden Rule. Some venture capitalists and other “professional“ investors have specifications before they will entertain an investment. For example, an investor might require a C corporation domiciled in Delaware. Period. Take it or leave it. Why?

Who knows? Perhaps that is what they have always done, and why change now? Or… perhaps that is how the investor was able to raise capital and the prospectus outlined this detail such as “all equity investments will be made into C corporations domiciled in Delaware only.”

By now you should have a good handle on the fact that a C corporation is a lousy tax vehicle and that Delaware only adds to your tax filing headache if you operate in a state other than Delaware. But! If that is what it takes to receive seed money for your big idea, then that is what you do.

Nuts and Bolts of Adding Another Owner

Let’s assume you have a single-member LLC, and you want to add a 20% member for $50,000. What are the accounting mechanics behind this transaction? It depends. If you are personally receiving the $50,000 then you are selling a part of your interest directly to the new owner which might create a capital gain to you, as a seller.

Conversely, if the LLC is receiving the $50,000 as a capital injection and carving out a 20% interest to this new member, this is not a taxable event. This also does not mean the business is worth $250,000 (1/5 = $50,000 so 4/5 = $200,000). When a business valuation is performed, the enterprise is valued as a whole, and then discounts are taken for lack of control (minority interest) and then lack of marketability (difficulty in converting ownership into cash).

Therefore, this $50,000 is just a number the two of you came up with based on some data. When that $50,000 is received by the LLC it becomes a part of the capital account of the new owner. This is a tax-less transaction for the existing or original owner(s).

Let’s recap this a bit. When adding an owner, you can-

• Sell or gift a portion of your interest or shares to them, or

• The entity can sell shares or “create” an interest in exchange for consideration (usually money but it could easily be another asset like property).

In the case of an LLC (versus a corporation), the second scenario is preferred. There is an election under Section 754 which allows a new member (partner) to receive a step-up in basis of the entity’s assets which might lead to additional depreciation and amortization benefits. The “754 election” as it is commonly tossed around at parties and accounting back alleys aligns the new member’s portion of inside basis (the assets inside the entity) with the outside basis (the investment by the new member). This can also occur when you buy out another member (partner).

Sorry for throwing you into the weeds on this little tax code issue.

Injecting Different Property

This is one of those Pet Shop Boys “I’ve got the brains, You’ve got the looks, Let’s make lots of money” sort of things. The best way of describing this deal arrangement is with a real-life example.

WCG has a client who helped a business (let’s call them ABC Co) develop a product. However, he wasn’t fully paid for his services (about $836,000) and was willing to get paid on the backend. The product cost about $7.5 million dollars to develop and ABC fronted all the costs.

They wanted to create another entity where our client was going to be a 25% owner and ABC was going to be the remaining 75%. Initial capitalization was low since our client did not want to realize any income until later. In other words, if the injected product was valued at $10 million, our client might have to realize the $836,000 deferred income as part of the $2.5 million capital account. There were a bunch of other basis issues that are not worth going into with this approach.

So, it was abandoned for a different arrangement.

The plan was to keep developing the product and eventually sell out to another business who would take it to market (a liquidity event). If this new entity sold for $12 million, then it would be easy to pay out $7.5 million to ABC and $826,000 to our client, and then split the remainder 75% – 25%. But what if it sold for $5 million? Who gets what and when?

We agreed on various tranches. Tranche 1, ABC received $2,500,000. Tranche 2, our client received $278,000. Then Tranche 3 was 90% ABC and 10% our client for the remainder of what was available. Finally, there was a Tranche 4 should the business be sold for more than $8.4 million or so that was split 75-25 (or along party lines of the member interests).

This was a shared risk approach. Certainly, ABC was the 800lb gorilla and wanted to recoup a big chunk first, but it was also willing to reduce our client’s risk as each tranche was satisfied.

These things are unique since they involve humans and emotions, and various risk horizons. But as they say, there are a thousand ways to skin a cat, and as such, only limited imaginations get in the way of a good deal.

Recap of Angel Investors

Are we suggesting avoiding these situations entirely? No. At times they are the only options available. We just want to let you know of the concerns and considerations. Marriage is all about love, and divorce is all about money. Business is no different, and in some respects can be worse.

The cool thing is that you have several options and you can certainly rip off best practices or other ideas, smash them up, and create your own plan.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

You can own different interests in an entity, and the most common are economic and equity. Generally, as an equity owner you are an owner of the business’s equity which includes its assets (tangible, and intangible such as goodwill) minus the liabilities and debts. This also typically means that your equity interest entitles you to a share of the proceeds upon sale (unless contracts and agreement state otherwise).

An economic interest is generally a share of the profits but does not necessarily entitle you to the equity or value of the entity itself. Many businesses will have a profit-sharing plan which is similar to an economic interest, however these are usually reserved for certain employees or groups of employees, and not necessarily memorialized in a business’s Operating Agreement. Here are some examples-

You work for Google and they have a profit-sharing plan where you receive a prorated amount of the allocated profit sharing based on a formula (such as salary and years of service). This is generally not viewed as owning an economic interest in Google, however Google probably has at least a contractual obligation to you.

You work for an accounting firm. You are paid 30% of the gross revenues less direct labor attributed to your efforts. This payment is made directly to you and bypasses payroll (i.e., not reported on your W-2). The Operating Agreement of the accounting firm reflects all this, and you are named a non-voting member. This is commonly regarded as an economic interest, and as such you are technically a partner in the accounting firm and will receive annual K-1s reflecting your earnings.

Subtle difference.

What’s the big deal? At times you might not want to immediately give away or sell the net worth of a business to a partner. Rather, you want to split the difference; you want them to feel like an owner, think like an owner and get compensated like an owner, without actually owning the sticks and bricks. Later, down the road and upon reflection, an economic interest can be piggybacked with or wholly converted to an equity interest.

How do the entity structures work with an economic interest? It is not much different than the arrangements discussed in this chapter. You could very easily have a multi-member LLC which has two equity members and three additional economic members. All five members would receive K-1s reflecting their portion of the business activities, however, only the two equity members would have capital accounts.

The previous example does not work where the MMLLC is taxed as an S Corp, and without leveraging S corporation elections the members would be pay unnecessary self-employment taxes. One solution is where the economic member owns an entity taxed as an S Corp, and the primary entity pays a fee for service to the S Corp (see previous section for schematics of how this mothership baby S Corp construct looks visually). Usually, contracts memorializing this fee for service arrangement are also created and executed.

So, a couple of lessons here. Economic interests-

• are wonderful tools to provide ownership in a sense,

• allow for baby steps of bringing in a new business partner, and

• can leverage the mothership LLC and baby S Corp concepts for tax efficiency,

Expanding ownership is tricky and it requires legal documents to be safe; but it is also unlimited in terms of buy-in arrangements, splits, vesting schedules, exit strategies, etc. We can help with the imagination! You’ll freak out because casting future unknowns in stone can keep you awake at night; we can also help make things malleable without being locked into a once-was-good-but-now-is-bad deal.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

Sounds like a drink doesn’t it? “Oh man, I was up all night pounding Cali Twists.”

The problem with the previous MMLLC entity structure that issues invoices or makes fee for service payments, is that this works well in most situations except California. It still works in California as a structure, but the tax expense, namely the LLC fee, makes this egregious.

California’s LLCs, including SMLLCs and MMLLCs, have an LLC fee based on gross receipts. Read that again. On gross receipts. If you make a $1,000,000 and have $950,000 in expenses, you still pay a franchise tax, called an LLC fee, computed on the $1,000,000.

The fee is “banded” as we say since it is not a straight calculation based on a percentage. As of December 2024, the following fees are reported by California’s Franchise Tax Board–

What makes matters worse is if the S Corps receiving income from the MMLLC are domiciled in California, they also must pay a 1.5% franchise tax on the net income after expenses (profit). Therefore, the same dollar might be taxed twice; once at the MMLLC level as an LLC fee, and again at the S corporation level as a franchise tax. Yuck. Super yuck!

What can be done? Simple! We elect the MMLC to be taxed as an S Corp. Hang in there on this one!

The graphic to the left is eerily similar to the previous one… except S Corp replaces MMLLC. The MMLLC is now taxed as an S Corp and Fred, Velma and Shaggy remain as shareholders. After paying the other S corporations a fee for Payments for Services Rendered or Outside Contractor or something similar, the MMLLC S Corp will have very little taxable income, such as $1,000. A franchise tax will be computed by California at 1.5% x $1,000 or $800, whichever is higher. Unavoidable.

The MMLLC S Corp would not pay salaries to its shareholders since the income is so low, and there isn’t any cash available. In addition, distributions theoretically should be $0 since all the cash is leaving in the form of payments to the other S Corps. There might be some goofiness if the MMLLC has depreciating assets or loans or some other transaction which causes net income to be something other than a $1,000 and shareholder distributions to be something other than $0 (we discussed this previously). The important takeaway here is the reduction of the LLC fee that California imposes.

The other S Corps owned separately by Fred, Velma and Shaggy would carry on as normal. Pay expenses related to themselves, pay salaries, provide distributions, etc. Fred, Velma and Shaggy would get two K-1s, one from the MMLC taxed as an S Corp and another from their respective S Corp. This is exactly the same as our previous schematic in terms of K-1s.

Loan Basis in an S Corporation

This is a relatively common issue and when it pops up it can be brutal. As a partner in a multi-member LLC taxed as a partnership, if you personally guarantee a loan for the business, you create what is called loan basis. In a simple way, this allows you to take out more distributions from the business without creating a “distributions in excess of basis” situation which subsequently creates a capital gain.

If we are in California and want to reduce the egregious LLC fee, we S Corp elect the primary entity or “mothership.” But under the auspice of an S Corp, you cannot create loan basis without the shareholder providing a loan directly to the S corporation. Huh? At the risk of belaboring this issue too much, consider the following-

You buy a piece of equipment for $100,000 and took out a loan in the business name including a personal guarantee. You deducted 100% of the purchase price using bonus depreciation. You had cash revenue of $100,000 and a deduction of $100,000 for the equipment leaving $0 at net ordinary business income. Nice! But, you have a $100,000 in the business checking account and like most business owners you sort of kind of would like to spend it.

In a MMLLC taxed as a partnership scenario, you would have created additional basis by guaranteeing the loan allowing you to distribute this $100,000 without creating a capital gain. In an MMLLC taxed as an S corporation scenario, the $100,000 distribution would be in excess of shareholder basis and capital gains taxes might be incurred. Your starting shareholder basis at the beginning of the year would not change since the business had $0 in net income. So, December 31’s basis equals January 1’s basis, but you have a bunch of cash earned from revenues and you used depreciation to reduce your ordinary business income to $0. Depreciation can be a cashless expense to reduce income. Good and bad, right? No taxable income, good. But no access to the cash without capital gains tax, bad.

Had the S Corp shareholders lent $100,000 to the business personally, then they would have created loan basis. Speak to your lender before doing some of this stuff! If your lender can give the shareholders the cash to lend or inject into the S Corp, and still retain a lien on equipment, that might be preferred.

This is not a showstopper per se, and we definitely geeked out a bit. Having said all this, there is a subtle difference we are not highlighting until right now. The above scenario is only problematic where you have a standalone S corporation. The three previous schematics were multi-entity arrangements with one distributing cash to the S Corp members as distributions and the other two distributing cash to the S Corps as fees for services or management fees or some other business to business mechanism. If the cash leaving the “mothership” is a distribution, this loan basis stuff can be a problem. If the cash leaving is a fee for service, this loan basis stuff is probably a non-issue.

Again, our apologies for getting into the weeds on this. We can always review your unique situation to help avoid this trap.

By Jason Watson, CPA
Posted Friday, October 20, 2023

There are some things you need to work through with the multi-entity arrangement. Depending on your situation, some of these things might be show-stoppers. However, don’t take the first answer as the only answer. A multi-entity scenario is super common among popular groups like doctors, lawyers, accountants and financial advisors. If your tax professional or accountant says No, push a little harder. Same with your vendor (see below).

By the way, WCG CPAs & Advisors is a C corporation and pays a fee for service to each of its partners’ S Corps. We know first hand the ins and outs of this arrangement since we live it. Why a C Corp? We also have employees who own shares but are not partners per se.

Health Insurance

Check with your health insurance broker or point of contact on how the health insurance needs to be administered. Do we have the primary entity pay for it, and each S Corp reimburses the primary entity? Can the policies be split up and paid by each S Corp separately, or does that mess up the group policy rates? These are questions that need to be explored; again, just because you have a certain look to your health insurance coverage today does not mean it is cast in stone.

At times when using a professional employer organization (PEO) to administer your payroll and benefits, you might need to process a small shareholder salary or guaranteed payment at the mothership level for each owner to allow for health insurance coverage. This is turn reduces the fee for service or management fee that is paid out (a small payout matrix might be created). The difference between salary and guaranteed payment is whether the mothership is a partnership or an S Corp.

Professional Liability

This is similar to health insurance, but ideally the policy should be maintained at the primary entity level. For example, WCG’s errors and omissions policy is held by WCG, but each partner is named as a principal of WCG and as such is covered by the single policy. This took minor coordination with our insurance provider, but since many accounting firms are set up similarly it was easy to add language in our Bylaws and Shareholder Agreements to satisfy. You might also have to name the S Corps as additional insureds.

Licensing and Compliance

We mentioned this previously, but we want to circle back on it again. Licensing and compliance can be a bit larger of a rock going up a bit steeper of a hill. If your trade or profession is governed by a regulatory body, you’ll need to ensure the multi-entity arrangement is in compliance. Typically governing regulatory bodies want to ensure two things; first, the people in control are the ones licensed, and second, the licensed people are the ones earning revenue from the practice. In other words, they don’t want some murky structure where a faceless business is practicing law or medicine, as an example, without individual licenses.

What has helped other licensed and certificated people is using the words “tax vehicle” when having this conversation. When explaining the multi-entity structure, try to focus on two things; the licensed people are still the people doing the work, and the structure is designed for tax efficiency. Luckily you shouldn’t be the first one to introduce this concept to your governing body. Hopefully they give you the “yeah, yeah, yeah… slow down sparky… here’s what we need from you to make this work” response.

401k Plans

We discuss this elsewhere, but 401k plans are ideally implemented at the mothership (primary entity) level, and then each baby S Corp adopts the plan as an adopting employer. Your 401k plan administrator should be able to help.

Depreciation

At times with the way the tax code works, especially Section 179, it might be challenging to drive net income down to a nominal amount in the primary MMLLC entity. Don’t get hung up on this since it is uncommon; however, it might create a self-employment tax on the residual income.

In addition, Section 179 has limitations at the individual tax return level, and as such it is reported separately on the K-1 to the member or partner. There could be a situation where one member or partner’s tax benefit is not proportional to his or her share of the revenue or profits. Don’t get hung up on this either since we can probably align this correctly within the tax return; it will just take some mental gymnastics.

Professional Fees

More tax returns increase tax preparation fees. If you were just a MMLLC with your partner, you had a single business entity tax return. Creating a multi-entity arrangement adds at least two more business entity tax returns (S Corp tax return), and possible more depending on how many partners or owners there are. You might also have additional payroll “systems.” One for clerical staff at the MMLLC level, and then one for each S Corp to pay out reasonable shareholder salaries to the owners.

Let’s put some math to this conundrum. A three-owner MMLLC without the mothership and baby S Corp setup, would have all-in tax preparation only fees of about $4,500 annually, or $1,500 per person. If the mothership MMLLC baby S Corp strategy is deployed, the all-in business advisory services fee for each S Corp is about $4,500 annually (tax returns, payroll, consulting, planning) and the MMLLC would be about $1,500 to $1,800. This is about $5,400 per person, or a delta of $3,900 per person.

Is the $3,900 in additional fees worth it? Perhaps. It is challenging to put a value on squishy things like flexibility, office politics, varying tax risk profiles, enhanced individualized tax strategies, etc.

Asset Appreciation

This one is goofy, and 99% of the time won’t come into play. But! If you owned a bunch of assets in your S corporation including an interest in the primary entity (the MMLLC), upon your death the S corporation would need to be valued to receive what is called a step up in basis. For example, you bought a house for $150,000. You die. The house is worth $500,000. Your heirs sell it for $500,000. There are no capital gains since the heirs receive a step-up in the basis to go from $150,000 to $500,000 upon your death.

The tricky part is valuing an S corporation since we would value the enterprise as whole. Sure, it would comprise of individual assets being assembled into an enterprise value but there could be some complication.

Another concern along these lines, which we also address in a later chapter, is the appreciation of assets. When you revoke an S corporation election or shutdown the business, the assets are distributed at fair market value. So, if your S Corp owns interests in the MMLLC, and that interest has increased in value, there could be capital gains taxes without a transaction.

We solve this concern using the previous schematic where the interests in the MMLLC are owned individually rather than through an S Corp. We only express this concern should your member interest be held within your S Corp.

Sidebar: We mentioned this in several different ways throughout this book, and we’ll say it again here. There is a strong desire to put everyone you own and do into your S corporation. Don’t! The primary purpose of an S Corp is to reduce the amount of earned income subjected to Social Security and Medicare taxes. Holding assets and investments in your S Corp rarely improves your tax position and usually yet unintentionally increases risk.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

As mentioned in other areas of this book, your family might benefit from adding children and / or parents to your entity. For example, you could have your children be 10% owners each. They in turn pay very little tax compared to you, and they can either gift the money back to you (good luck) or you can surrender and use this ownership method as a conduit to give them your money which is going to happen anyway but at a reduced tax effect. Imagine helping them pay for basic living expenses, college or savings using business dollars while reducing your overall taxes? Nice, for sure, but it takes some planning.

For example, they are 25 years old making $50,000 on their own. Your business had net profits of $250,000. Because of exemptions and deductions, your child is in the 10% marginal tax rate whereas you are in the 22% marginal tax rate. Not a huge swing, but you get the idea.

Other examples include minor children. Yes, a minor can own shares in an S corporation or generally own interest in an LLC. However, given kiddie tax rates (even with the recent SECURE Act) this might not be beneficial since your child could be taxed at your rate. What if the minor child materially participates in the business activities? Huh?

There are seven tests for material participation, and the easiest one for your child to meet is 500 hours per year (or about 10 hours a week). The activity must also be regular, continuous and substantial (this is straight out of the ATG – Audit Techniques Guide from the IRS). There are other tests that are preferred when you are needing to claim material participation (such as for the short-term rental tax loophole) but they are not as easy for your child. See the WCG CPAs & Advisors blog for more details.

Back to the issues at hand. If you nail down the material participation with your minor children, they can earn income and be taxed at their own tax rate as opposed to your tax rate. Yes, they can gift the money back to you for your bar bill or make a contribution to their retirement accounts. We prefer the former naturally.

Wait! There’s more. You can still claim them as a dependent if you provide over half of their support. How expensive are kids? Really expensive! The word “support” is very interesting. Here is an example; your child could earn $20,000, and puts $15,000 into savings to one day buy a house. They also have $12,000 in living expenses. If you paid $6,001 of those expenses, you are providing over 50% of their support and the child can still be your dependent. Seems a bit silly, but it is good tax planning just the same.

Your Mom and Dad can qualify for this as well where you could siphon income and distributions off to Mom, and she will be taxed at her income tax rate. Also, if you own and operate an S Corp, you don’t have to pay a salary to shareholders who do not materially participate in the business activities (inactive shareholders).

Let’s recap the idea of children and parents being owners. The practical theory is that if you are going to provide $1,000 for your children or parents, it takes $1,300 or $1,400 in total cash assuming your tax rate is higher than theirs. Moreover, you could “gross up” the $1,000 to account for taxes at their rate and still come out ahead overall in cash (which is what we all care about).

Keep in mind that the juice might not be worth the squeeze. If you are going to deploy these tax strategies, another zero is probably needed.

Family Problems

Yuck but real. Thanksgiving becomes super awkward when the pressures of business ownership span family members including in-laws. A lot of discussion and even disagreements between business partners are absolutely necessary for successful business stewardship. But retreating to neutral corners is tough with the entire family watching.

Wait! There’s more. If you get divorced from your spouse, it is crummy and a bit messy. You own a business interest with your spouse’s sibling, and a bit messy becomes a real problem.

Imagine you owning a rental property with an in-law. You might not be able to exit gracefully; regardless of fault, your in-law is sitting on your ex-spouse’s side of the room and backing every play. You might not be able to buy him or her out either if the asset has appreciated substantially. Lovely, just lovely.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

You might be in one of three situations. First, you have a partner in your business already and there’s no getting around it unless someone meets with an accident. Or, you work alone like Lone Wolf McQuade (first Chuck Norris reference) and don’t see that ever changing. Now the remaining situation allows for a fork in the road- either to add a partner now as you form your business or later after things stabilize a bit. Regardless of having a choice or your spouse allowing you to believe that you do, you contemplate adding your spouse as if it was your idea all along.

Married Couple as Owners

Should you immediately form an LLC with your spouse? No. Don’t you see enough of each other at the house? All kidding aside, there are two scenarios at play here. First, adding your spouse as an owner and second, adding your spouse to payroll as an employee only. Just because your spouse is an owner does not mean he or she needs a salary, and he or she does not need to be an owner to receive a salary. While those scenarios are commonly combined, it remains a choice, and each has very specific objectives.

We’ll look at ownership first, and touch on the payroll component in a later chapter. Two primary reasons for adding your spouse to the business as an owner are-

• Leverage the minority owned small business benefits (usually with government contracts). This is getting less and less lucrative.

• Asset protection through Charging Orders and the associated rules with multi-member LLCs (attorney stuff).

• Your spouse suggests it one lovely evening over dinner, and upon reflection of considerable collateral damage, you surrender. A solely owned small business is still a marital asset in most jurisdictions and as such will be part of any divorce action regardless.

We tricked you there into thinking there were only two primary reasons. Gotta have some fun with this material, right?!

Back to business; please note how tax savings or other big “wow” things are not listed. In other words, adding your spouse as an owner only has two super narrow bands of benefits.

Two Options

If you and your partner are married, and want to become the next power couple, you have two basic options-

• Elect to be treated as a qualified joint venture (as defined and allowed by the IRS), and file on Schedule C on your individual tax returns, or

• Form an entity, treat the entity as a partnership and file accordingly (either Form 1065 or 1120S).

How you arrive at these two options will vary depending on your state’s property laws. There are two types of states beyond red and blue; community property and common law property. Here is some gee whiz information. Community property laws stem from Spanish law whereas common law property states originate from the English law system. Therefore, it makes sense that most of the community property states are in the southwest portion of the United States plus the odd ducks up there in Wisconsin, Washington and Idaho.

Community property states dictate that the income is added into a “community” pot, and then divided equally between the joint taxpayers. Federal laws will usually follow the state laws in terms of income joining and splitting, with some exceptions here and there. On a jointly filed tax return this is moot, but if you need to file a separate tax return this gets complicated (separate tax returns are occasionally needed for second marriages or prenuptial agreements). But regardless of the taxation issues, there are also some procedural issues with business ownership.

Community Property State

Two people, married, in a community property state are not a partnership unless they elect to be treated as such. If you are not electing S corporation status now or in the near future, we would advise not to elect to be a treated as a partnership. Keep it simple.

Electing to be treated as a partnership will complicate things from a tax preparation perspective, does not provide any added tax benefit, and forces you into one of two situations, which are both ultimately equal. You could prepare a partnership tax return and create separate K-1s for you and your spouse at 50% each, or prepare a partnership tax return and create a joint K-1.

Please recall that a K-1 is the byproduct of a pass-through entity tax return which summarizes various business activities that are later presented on the owners’ individual tax returns (Form 1040).

What the heck is a joint K-1? Rare, Yes, but the K-1 would be issued to the primary taxpayer’s SSN but read “Bob and Sue Smith, JTWROS”. When your individual tax returns are prepared, this joint K-1 gets spread among both you and your spouse equally, and therefore the income might be taxed with additional, unnecessary Social Security taxes.

Don’t like that idea? Sure, an S Corp election solves the issue above, but here is an alternative that saves you some tax preparation fees since you avoid the partnership tax return but remains “tax expensive-“

A husband and wife owning an LLC in a community property state can be considered one owner, or in the case of an LLC, one member and therefore becomes a disregarded entity as opposed to a partnership. The business activities are then reported on Schedule C of your Form 1040. However, if you properly prepare your individual tax returns, you will split the business activities equally between you and your spouse.

Sidebar: An individual tax return is a bit of a misnomer. It is synonymous with Form 1040, and may be filed as one person or two married people (married filing jointly). In both situations, the tax return is called an individual tax return. Many of us think of the word individual as numerical such as one or single. But in the case of tax returns, individual is better known as person or human. Furthermore, a married couple is considered one in so many walks of legal life, hence the singular use of individual in referencing a tax return.

Let’s run through these three tax return scenarios once more when a married couple own a business together in a community property state-

• Elect partnership with separate K-1s at 50% each, or

• Elect partnership with joint K-1, or

• Remain a disregarded entity (single member LLC) and evenly split activities on two Schedule Cs (you and your spouse), and report them collectively on your individual tax returns (Form 1040).

All three of these scenarios are identical from a self-employment and income tax perspective. Remember, each person has to pay Social Security taxes which is the bulk of the self-employment tax equation up to $176,100 of income (for the 2025 tax year). So, if you are forced to push income equally to you and your spouse, you could easily pay more self-employment taxes than necessary.

You may avoid this by being a single-member LLC. Read that last tidbit again. As mentioned just a bit ago, splitting up your income might actually increase your overall tax liabilities. Remember grammar school; may is permissive and might refers to chance. You may go to the bathroom. It might rain today. It’s a bit laughable when flight attendants state that your nearest exit may be behind you as if the exit submitted a proposal for its desired location. Oh well.

Back to more business; two scenarios to drive home this point-

• Scenario A- The business earns $300,000 in net income after expenses (profit). You pay Social Security taxes up to $176,100 for the 2025 tax year, and Medicare taxes on the whole amount.

• Scenario B- The business earns $300,000 in net income. You and your spouse pay Social Security taxes up to $150,000 each if your spouse is also a member or partner in the business, or about $17,000 in unnecessary taxes which is cash out of your pocket. (Yes, an S corporation could alleviate some this, but you get the idea).

The only way to avoid this equalization in a community property state is to file separate tax returns and claim that you did not know about the community income (seems farfetched, Yes). You could always move to a common law property state such as Colorado which is lovely (we promise).

Or, prove to your family and friends that you are trainable by reading this book, and not add your spouse to the business entity. This is the most elegant and preferred choice when living in a community property state and wanting to avoid the additional Social Security tax as illustrated above.

Or, eclipsing the threshold where an S corporation election makes sense, which we will explore in fascinating detail.

Note: Making an S Corp election can prove problematic if your spouse is a nonresident alien or if your spouse does not consent to the election (even if he or she does not own the business with you). More on this later.

Common Law Property State

Similar to community property states, a husband and wife (or same-sex couples) living in a common law property state have two options- file a partnership tax return or elect to be a qualified joint venture.

Two major differences to note here right away; in common law property states, the presumption is that you and your spouse are a partnership. In community property states, the opposite is true. The presumption is that your business entity is essentially a qualified joint venture.

The other major difference is that in a common law property state, you can chop up the business activities based on a pro-rated basis of involvement / interest in the business. For example, your husband supports your consulting business by handling the books; perhaps his involvement is only 15%. This is converse to community property states which generally divide things equally (whoever thought a marriage was a 50-50 relationship was fooled long ago, but here we are).

Some other details allowing married business partners to be a qualified joint venture include the following-

• You and your spouse are the only members (owners) of the joint venture, and

• You file a joint tax return (Form 1040), and

• You both materially participate in the business operations (which has legal IRS definitions attached to it such as number of hours and activities), and

• You are not operating the business as a limited liability company (what?!).

The last one is the deal breaker for most people. According to IRS rules, if you and your spouse operate a multi-member LLC, whereby each of you are members of the LLC, then you must file as a partnership using Form 1065 in common law property states. Most people are confused on this including attorneys and other CPAs. Don’t believe us? No worries, refer to these wonderful IRS resources-

wcginc.com/5401

There is a flimsy reason why a qualified joint venture for a husband-and-wife team might make sense over a partnership. A disregarded entity (single-member LLC) or a husband-and-wife team that elect to be a joint venture can theoretically have unlimited losses reported on Schedule C of your joint Form 1040 (assuming the money invested is at-risk).

This contrasts with a partnership where your losses cannot reduce a partner’s basis below zero. In other words, if you invest $5,000 in a partnership you can only lose $5,000. Without going into crazy detail, this is different than a partner’s capital account (for example, you inject property into the partnership that is worth $10,000 but you only paid $2,000 for it, your capital account will show $10,000 but your basis in only $2,000). Sorry for the diversion.

Having said all this, WCG still prefers to file partnership tax returns even for married couples in community property states since it allows us to track your capital accounts and other basis information. If you sell the business or get divorced or bring on a new partner, then this history is readily available. Otherwise, you must rebuild this information.

Additionally, the audit rate risk is much lower for partnership tax returns than individual tax returns. This does not mean you can be cavalier with your tax positions, but it certainly provides comfort in having a lower risk in defending them. We expand on this in a bit.

If a narrow reason exists, the qualified joint venture election can be made on Form 8832. Here is a quick summary table for married couple teams-

You might be saying to yourself, Yeah, but there have to be some good reasons to add my spouse to the ownership. Here are some considerations.

Disadvantaged Business

Women are a protected class, and therefore might receive favorable government contracts or grants as small business owners. Same sex couples might see increased favorable treatment as well. Don’t forget about Veterans and other groups of people whose status might be leveraged.

There are several acronyms out there-

Yeah, okay, the last one was a joke. You should always explore these opportunities especially if you are engaging with governments. There are also businesses who will certify your entity as one of the above since there has been a lot of fraud lately. Shocking. Say it isn’t so!

Charging Orders

When you have a multi-member limited liability company, and there is a judgement against a member of the LLC, the creditor must obtain what is called a charging order from a court. Theoretically this forces the creditor to only receive distributions from the LLC rather than the LLC’s assets. Adding a spouse creates a multi-member LLC situation, but there are some caveats. A later chapter has more information on the concept of charging orders (spoiler alert: it is flimsy legal defense for owners who are married to each other).

Audit Rates

According to IRS data for the 2019 tax year (the most recent data set), 9.3 million partnership and S corporation tax returns combined (Forms 1065 and 1120S) were filed. Of those, 17,543 were audited for an audit rate of less than 0.2%. This further breaks down to 15,852 as a field audit (face to face at your place of business) and 1,691 as a correspondence audit (letters). The IRS is slow to compile and release this data, but we doubt the trend has shifted.

Of those audited by a field audit, 35% resulted in a no-change audit whereas correspondence audits resulted in a no-change audit 52% of the time. This is a blended rate, and digging deeper into the data reveals that partnerships generally result in a no-change audit about half of the time, whereas the same result for an S corporation happens about 33% of the time.

Audit rates for individual tax returns (Form 1040) for the 2019 tax year for adjusted gross income between $50,000 and $200,000 was 0.1%, whereas $200,000 through $1,000,000 was 0.4%. These rates increase to 0.6% and 1.0% respectively with Schedule C and Schedule E. Therefore, if you are in this second band of income range, a partnership or S corporation tax return will have half the IRS scrutiny as your individual tax return. To say half is a bit misleading, right? In practical terms, your audit rate risk goes from microscopic to tiny… both scenarios are favorable, but you get the general idea.

Reduced Salary

Assuming an S corporation, if your spouse is an inactive owner of the business, then the operating spouse’s salary might be reduced. For example, one of the criteria the IRS will use to determine if your salary is reasonable is the comparison to shareholder distributions. As we will discuss further in our chapter titled reasonable shareholder salary, one of the jumping off points is 1/3 of net business income after expenses and from there we massage the number to suit the operating spouse specifically.

But if this 1/3 number is based on an ownership percentage less than 100% (such as 80% for the operating spouse and 20% for the inactive / investing spouse), then there might be some savings.

1/3 of 80% of $100,000 is $26,600
1/3 of 100% of $100,000 is $33,300

A $6,000 reduction in salary could save you over $900 in payroll taxes! Again, a later chapter has more information on this within the reasonable salary determination arguments.

Another way to look at this is this; if the IRS uses distributions as compared to salary as one of the determinants of reasonableness, you lower your distribution by shifting some to your inactive spouse. So, your ratio of distributions to salary is lower which is good. Note the words “some” and “inactive.” Some being reasonable like 20% or less. Inactive being an owner who does not materially participate in the business and can warrant not collecting a reasonable shareholder salary.

Net-Net Spouse Summary

Again, assume an S Corp. On one hand you have the option of making your spouse an inactive shareholder which theoretically could defend a lower reasonable salary. For mid-range salaries ($30,000 to $50,000), your savings could be $900 to $1,500. Okay, that’s one side of the coin.

The other side is adding the spouse as a shareholder and employee (or just employee) and expanding business tax deductions such as business meals, and adding contributions to solo 401k plans. What does that get you in terms of money? At a 24% marginal tax rate, if you were to reduce taxable income by $10,000 because of additional business deductions, you save $2,400.

Therefore, the ultimate answer is weighing the payroll tax reduction (inactive shareholder) versus the income tax reduction (spouse as employee). Remember that the income tax deduction is not generated by solely giving your spouse a wage (assuming you file a joint individual tax return). The income deduction is generated by justifying increased business spending and solo 401k plan deferrals. By the way, a solo 401k plan is available to a married couple team which is contradictory to the word solo… unless you both have one heartbeat and all that mushy stuff T-Swift sings about.

The best trick is to find a legal way to take the money you already spend and turn it into a small business tax deduction. Employing your spouse might help. Thumb through your family expenditures and see if you could have attached a business purpose them.

Married Couple Problems

Staying with the S Corp version of adding your spouse as an owner, if you are trying to classify your spouse as an inactive investor of the business, then you cannot pay a salary. This ultimately prevents your spouse from participating in a 401k plan, and expensing business meals and travel becomes challenging.

Another concern are certain professions- law, medical and accounting do not allow non-professionals to be owners in most states. For example, to be an owner of medical practice requires that you are also a medical doctor. There are some minor exceptions here and there, and each state is different. Over the past several years, however, ownership rules are loosening in all professions. For example, the medical industry has learned that doctors make lousy business administrators and are allowing medical practices to leverage smart Harvard MBA types to run the business.

Here is another example; in Colorado a non-CPA can be an owner of a CPA firm, but the majority (51%) must be CPA’s. There are also supervisory and control rules as well. This is a reflection of the times since CPA firms are now offering so many services such as software implementation and real estate consulting. To say that a person cannot be a partner because he or she does have a CPA credential but yet are very valuable to the success of the firm is not equitable.

The overall theme is to double check with your local regulatory agencies first.

Ownership Transfer with Married Couple Teams

If you are concerned about ownership transfer in case of death, we suggest taking care of this issue within your estate planning. Transfer of assets between spouses during death is generally seamless in most states. Contact an estate planning attorney for more comprehensive analysis and advice.

If you are concerned about separation of property during divorce, our experience and observation show that a single owner will still be required to obtain a business valuation from an expert and the business becomes a marital asset. Most courts use a method such as excess earnings to determine the value to the operating spouse, not necessarily the fair market value.

For example, a one-person consultant with a single client might not be able to sell the business because no one else could do the work. However, the business remains valuable to the operating spouse. This is the same as the POS you drove in college- you could sell it for $50, but to you the car was worth a zillion dollars. It ran well, the heater worked, got you to class or work on-time, etc.

Business valuations for divorces sounds like fun, doesn’t it? A real hoot. WCG is heavily involved in forensic accounting and business valuations, so if you need help let us know. Remember, the goal of any divorce is to ensure both parties are equally upset. No one should be high-fiving as they leave the courtroom.

By Jason Watson, CPA
Posted Saturday, September 7, 2024

The previous section was about holding companies versus management companies, but this particular LLC holding company variant does not have any commercial activity. What are we talking about here? Let’s say two people want to own an airplane. They could title it in their own names such as Buzz Aldrin and Amelia Earhart JTWROS. The fancy JTWROS is joint tenancy with rights of survivorship. This means that should Amelia die before Buzz, typically Buzz would absorb her interest in the airplane.

Time moves along, and Buzz and Amelia want to bring in Pete Mitchell as a third owner. They could add Maverick to the title because no one really knows who Pete Mitchell is, but this gets a bit cumbersome. If you add financing with personal loan guarantees to the mix, it could get messy if the bank wants to re-write the loan docs to add Pete… err… Maverick.

Rather, Buzz and Amelia would create a multi-member limited liability company (MMLLC) called The Little Red Bus LLC. This entity would hold title to the airplane but it would not have any commercial activity. The LLCs’s Operating Agreement would dictate how members could come and go, what happens if one member passes away, and other entity governance items. Therefore, when Pete Mitchell wants to be a part-owner, he would simply acquire member interest in the LLC. Title would not change since The Little Red Bus LLC owns the airplane, and Buzz, Amelia and Maverick own the LLC. Loan documents would not change, but perhaps an additional personal guarantee would be required.

LLCs are being used more and more in non-commercial or non-operating environments to make transfer of ownership super easy. We see this with boats, exotic car collections, art, among other things. Also, since there is no commercial activity, a tax return would not be required. Yes, an EIN would be necessary for a business banking account, but that in itself does not trigger a tax return filing requirement.

By Jason Watson, CPA
Posted Saturday, June 22, 2024

The past handful of sections have discussed the various considerations of the mothership baby S Corp multi-entity arrangement. Another consideration is rather than the mothership being a multi-member limited liability company (MMLLC), it is a for-profit C corporation. Owners would be shareholders versus members / partners. Entity governance would be Articles of Incorporation with Bylaws and Shareholder Agreements versus Articles of Formation or Organization and Operating Agreements. Gee whiz, right?

Hang in there… here are the things to think about with a C Corp as the mothership.

Paying Members for Services

IRC Section 707(a)(1) reads-

This doesn’t really tell us much, but there is some case law that suggests that the member must provide services to the LLC that are different from the activities for which the LLC was created or operated. For example, let’s say a partner provided accounting services to a CPA firm by preparing a tax return for the firm’s client. This suggests that the services provided are the same as the activities of the LLC.

However, there is case law suggesting that paying this same partner is not a problem at all. Slightly different facts with slightly different courts with all human nuances you would expect.

Keep in mind that the mothership baby S Corp does not avoid or reduce taxable income and therefore does not impact income taxes. Moreover, self-employment taxes might be reduced, sure, but they are reduced if the mothership elects to be taxed as an S Corp just the same (without the baby S Corps). As such, how is the IRS damaged?

Having said all this, a C corporation where you have shareholders (and not LLC members) might sidestep Section 707’s interpretive concern.

No Mothership K-1

Corporations naturally do not issue K-1s. This in itself might not be that exciting, but it does shrink the mothership owners’ tax footprint. If the entity is operating in California but one owner lives in Texas, and the entity issues a K-1 albeit a small one it still allows California to snoop around. They love to snoop and make wild assumptions.

Increasing Working Capital

When you increase working capital in a MMLLC, this usually increases net ordinary income on the K-1 issued to each member. As such, there is taxable income without cash, and that taxable income is computed at individual tax rates with the highest bracket being 37% federally. A C Corp would only pay 21% to increase working capital.

Why does increasing working capital increase income? In a mothership baby S Corp environment, profits are driven down close to zero with payments to the baby S Corps. This requires cash. Therefore, retaining cash prevents the mothership from reducing profits with payments to the baby S Corps. Sure, you could accrue the expense as a liability without cash leaving, but that can get challenging to reverse (make the payment) in future years without creating the very problem you are trying to avoid.

Using a line of credit solves might solve the working capital taxable income conundrum since the delta between 37% and 21% is likely to be higher than the tax-effected interest expense. Something to consider.

Ancillary Benefits

As mentioned in other parts of the book, a corporation allows you to issue stock to employees without the mess of member interest and the subsequent K-1 of an LLC.

The corporation might qualify for the Qualified Small Business Stock (QSBS) exemption upon sale. Loosely, Section 1202 of the Internal Revenue Code offers taxpayers (other than corporations) the potential to permanently exclude from taxable income $10 million om capital gains recognized in connection with the sale of the corporation. Yes, there are rules.

Summary

Here is a summary of the various scenarios in a multi-entity arrangement using the mothership baby S Corp construct-

• The mothership is an LLC and each member is an S corporation (the baby S Corps holds the interest in the LLC). This can be bad if crossing state lines between mothership and baby S Corp.

• The mothership is an LLC and pays a fee for service or management fee to the baby S Corps. This might be bad given some of the interpretations of Section 707.

• The mothership is a C corporation and pays a fee for service or management fee to the baby S Corps. All the taste of the mothership baby S Corp environment without the possible calories of Section 707, plus all the benefits above.

By Jason Watson, CPA
Posted Sunday, October 22, 2023

Using the previous example from this chapter, the two insurance agents could simplify life by entering into a joint venture agreement that allowed for revenue and expense sharing, without the formality of the business entity structure above.

Be careful here however! The IRS could impute that this is a partnership and demand a partnership tax return. Not much more will be said here since WCG is not a huge fan of joint ventures in this fashion, and most attorneys say it is very expensive to draft the necessary agreements. Automobile manufacturers have the budget to enter into large joint ventures with finite timelines (like business flirting), and also have a myriad of highly visible problems (brand, employee groups, regulations, etc.).

By Jason Watson, CPA
Posted Saturday, October 21, 2023

Ryan Fleischer tempted fate with an unreasonable salary and brought a case to the Tax Court that has reverberating consequences. In our opinion, had he been reasonable with his S Corp salary we wouldn’t be faced with this issue. As the saying goes, Pigs get fed and hogs get slaughtered. We are not comparing Ryan to a hog of course, but we are certainly mindful of the risks people take. Those who try to take too much end up in trouble.

Did Ryan try to take too much? It is hard to say since that is a matter of opinion. So, what is the issue?

Ryan Fleischer was a financial advisor for LPL and Mass Mutual, and he received payments and ultimately a 1099-MISC to himself personally. Per FINRA’s Rule 2040 compensation payments cannot be made to an entity unless that entity itself is a registered broker-dealer (and in some cases a Registered Investment Advisor, an RIA).

Ryan would report this income on Schedule C but then have a singular line item for “Other Expenses” resulting in a $0 profit. Too convenient, right? Through a random audit, the IRS issued a tax deficiency for all the years in question amounting to over $41,000. Here is a summary of his business income and salaries-

The salaries seem to jump out, don’t they? According to the Bureau of Labor Statistics, a personal financial advisor’s median 2017 pay was $90,640. Keep this in mind as we explore some other issues. Quick math would suggest that his salary was about a third of what the median salary was in 2017.

The case was docketed as Fleischer v. Commissioner, Tax Court Memo 2016-238.

The Tax Advisor’s March 1, 2017, article summarized the crux of the Tax Court’s decision-

The Tax Court stated that, based on precedent going back to the Supreme Court’s decision in Lucas v. Earl, 281 U.S. 111 (1930), “the first principle of income taxation is that income must be taxed to him who earned it.”

In a case involving an individual and a corporation, the question that the court must ask is, “Who controls the earning of the income?”

For a corporation to be in control of the income, two elements must be present:

(1) The individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense; and

(2) “there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation’s controlling position” (Johnson, 78 T.C. 882, 891 (1982)).

The Tax Court essentially agreed with the IRS since Fleischer was named on the contract with LPL and Mass Mutual, and not his S corporation. However, as mentioned before, FINRA’s Rule 2040 was designed to make financial advisors accountable and transparent, but it also created a roadblock from a tax efficiency perspective. In other words, had Fleischer provided consulting services to a singular client, he could have entered his S Corp into a contract with the client and the client could issue a 1099-MISC to his S Corp’s EIN.

What can be done? First, the easiest thing to do is amend the contract between the financial advisor and the broker-dealer / investment advisor firm to give the S Corp privity to the contract (or some sort of recognition). The next step is to enter into an employment contract between you, the financial advisor, and your S Corp plus updating the Bylaws and Shareholder Agreement. Please contact us for some sample language that we’ve seen others use.

There is a company called Succession Resource Group (SRG), Inc. who positions themselves as being able to defend the “Fleischer issue,” and their contact information is 503-427-9910 and info@successionresource.com. Give them a shout. Again, according to SRG these provisions satisfy the Tax Court’s big gripe. That is the easy stuff, and it might require legal assistance.

For long-term success consider that the world of financial advisors is changing dramatically. Most are leaving the broker-dealer world of commission sales for the investment advisor world of advisory fees. FINRA generally governs broker-dealer representatives while the SEC governs investment advisor representatives (the B/D versus IA worlds).

Further, a lot of financial advisors, investment advisors, Certified Financial Planners, etc. are creating their own Registered Investment Advisor (RIA) firms and electing those to be taxed as an S Corp. Yes, registering your firm as a broker-dealer or registered investment advisor (RIA) with either the State or SEC (depending on size) can be expensive. Most RIAs can be formed for about $6,000 where broker-dealers are much more cash intensive between the registration fees and the capital requirements.

The other option, as other business consultants have kicked around, is to prepare a Schedule C with the income related to the activities governed by FINRA as issued on a 1099-MISC. From there “cost of goods sold” expenses such as advisor fees, technology fees, insurance and other expenses directly related to the generation of that income are deducted.

Next a consulting arrangement is entered into between the financial advisor and the S Corp to provide marketing and consulting services to the financial advisor. Lastly, the Schedule C has some nominal profits remaining and the S Corp pays out a reasonable salary from the consulting arrangement. See the schematic below.

Does this appear like an end-around? Perhaps. Is it unreasonable? No, we do not believe so but at the same time this position has not been directly tested. Again, the tax discrimination that occurs simply out of a securities rule from FINRA is patently unfair given the financial burden of compliance. Fleischer sells his knowledge as a consultant, good to go. Fleischer sells his knowledge as financial advisor, no good. A technical housekeeping glitch is preventing good tax planning that most small business owners are able to receive.

Ryan Fleischer was well-represented by Howard Kaplan who pitched several good arguments, but in the end he lost. Ryan did not want to appeal to Federal court since he already spent $50,000 in legal fees; he might have also felt like his position was untenable given the current legal landscape. Unfortunately, this case shines a bright light on the common practice among tax professionals to nominate the income from an individual’s SSN to his or her S corporation’s EIN.

In our opinion, and the opinion of several other legal and tax professionals, had Ryan paid himself a reasonable salary he wouldn’t have gotten spanked so hard by the IRS. But that is conjecture, and certainly wasn’t an opinion expressed by the Court. However, in conversation with Ryan, he stated that the IRS audit was random yet he strongly feels it was deliberate because of his political party registration. Draw your own conclusions.

Having said that, our recommendation remains to start heading towards registering your business such that you can enter it into a contract with the broker-dealer / investment advisor firm.

By Jason Watson, CPA
Posted Saturday, October 21, 2023

What happens when you have an S corporation but want to implement an ESOP? First, what the heck is an ESOP. According to a May 2017 article in the Journal of Accountancy–

ESOPs were created by the Employee Retirement Income Security Act of 1974 (ERISA), P.L. 93-406, and have long been used as a vehicle for ownership succession planning. According to The ESOP Association, there are approximately 10,000 ESOPs in the United States, covering 10.3 million employees. While ESOPs exist in a broad range of industries, they are most prevalent in manufacturing and construction companies, as well as engineering and architecture firms.

The basic gist is that the present owners sell their shares to the ESOP and typically take back a note from the ESOP (a loan). The ESOP can also obtain outside financing to purchase the outstanding shares. From there the business provides the funding to the ESOP to pay its debt obligation.

Of course, there are stats everywhere suggesting that employee recruitment, retention and satisfaction all improve with an ESOP… but that can be costly too. According to the National Center for Employee Ownership (www.nceo.org) and affirmed by a Journal of Accountancy article, the cost to set up an ESOP which includes the feasibility analysis, paperwork and initial valuation ranges from $40,000 to $80,000 (and higher). As such this requires some careful consideration.

However, succession planning is important in certain businesses. If you are a one-person engineering consultant perhaps succession is simply riding off into the sunset. Like Def Leppard sings, it is better to burn out than to fade away. But if you have a business that you would like to see carry on my wayward son while you fade away, like a smash up of Def Leppard and Kansas, then an ESOP might be the answer.

There is no need to regurgitate information that is readily available elsewhere. Please understand two things; first, ESOPs can provide some immediate tax benefits and second, S corporations have more limitations and annoyances than C corporations with respects to ESOPs. Here are some links-

wcginc.com/6113 (NCEO’s article on ESOPs and S Corporations)

wcginc.com/6111 (Journal of Accountancy on ESOPs in a CPA Firm)

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.

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 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).

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 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.

Balance Sheet

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.

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.

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).

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 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.

Hybrid Accounting

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.

By Jason Watson, CPA
Posted Friday, October 20, 2023

Imagine you and another person want to form a business together, but you live in different states such as Minnesota and North Carolina. Where do you put the entity? In the end, it doesn’t matter since you would probably have a foreign filing registration requirement in the other state. So, you domicile the entity in Minnesota but also file as a foreign entity in North Carolina.

What’s the big deal? States get all bent out of shape on nexus and income apportionment. We have a whole chapter on this nexus stuff, but let’s do a quick preview. Generally, there are two types of nexus triggers, either economic or physical. Economic refers to how much “business” is being conducted commonly based on revenue. Physical nexus is commonly viewed as “boots on ground,” such as people or contractors (payroll), furthering your interests or “bricks and mortar,” such as offices (property). What makes it slightly confusing is that most states attach a dollar amount to payroll and property; as such the mere existence doesn’t necessarily mean you trigger nexus unless it exceeds a dollar amount.

So, the three nexus triggers are revenue, payroll and property. With sales tax nexus (as opposed to income tax nexus), the recent Wayfair decision has upheld the concept of “substantial” economic presence where essentially enough economic activity equals physical presence. Again, the Wayfair decision was about sales tax nexus, and not income tax nexus.

Sidebar on Nexus: This is similar to driving under the influence (DUI). Let’s say your state has a 0.08% blood alcohol limit. You can still be considered driving under the influence even if you have less than 0.08%. However, if you are over 0.08% then the state automatically presumes you are driving under the influence no matter how well you walk the line or touch your nose. This is called a “bright line.” States may argue you have nexus even if you do not cross the bright line, but if you do cross the bright line then it is automatic without argument or anything else to support it. Does that help?

If you trip the nexus wire, then the entity is on the hook for apportioning the taxable income among multiple states based on various formulas. One of the factors is naturally revenue, so if you trip nexus in two states, you must source revenue to each state. Next, each owner now has an income tax obligation in multiple states and is required to file non-resident tax returns in each state outside of his or her resident state. This is unavoidable, but what is avoidable to some degree is the scrutiny. How’s that?

Using our Minnesota and North Carolina example, if the entity is domiciled in Minnesota, you might have to convince Minnesota that a big chunk of the taxable income is not theirs (i.e., the revenue earned in North Carolina). We find ourselves having to connect dots for revenue agents often since you commonly must report all revenues earned, and then split them off to other states. As such, states get to peer into your world and then make you defend it. Yuck.

Solution? We usually create an entity in Wyoming or some other “tax-inert” state, and then also create entities in each resident state of the owners. All revenues pour into the Wyoming entity which in turn pays out revenues as fees for services to the other entities (Minnesota and North Carolina, in our example). Does this allow the Minnesota owner to avoid North Carolina taxes? No. Taxable income is still apportioned between states, and each owner has an income tax obligation in multiple states. What this does, however, is reduce the scrutiny triggers since you only need to “show the cards” that are pertinent to each state.

This also avoids the discussion of K-1 income as well. K-1 income is generally considered investment or passive income, but if you materially participate in the generation of that income, it might be considered non-passive income or for some limited purposes, earned income (like for use with foreign earned income exclusion). What are we getting at here?

Let’s run through an example (we explored this earlier, so this might be duplicative to some readers)-

Your Illinois S Corp is part owner of a California multi-member LLC that conducts business in several states. The MMLLC issues a K-1 to the S Corp for the pro rata ordinary business income, and then also apportions that income among the various states. California might argue that all the income to the S Corp is California income since the MMLLC is in California. But in reality, all the income came from other states and only made a pitstop in California. California might want to change the genesis of the revenue based on this alone.

Furthermore, California might consider the K-1 income to not be revenue or sales income at all. In other words, they might consider it investment, passive or non-passive income. Anything but revenue! Having it not be revenue or sales income prevents you from apportioning the revenue among several states, and possibly dipping below the economic nexus thresholds.

In summary, having the multi-member LLC issue payments for services provided to the partners’ S corporations reduces the visibility that states have. Again, we are not doing anything wrong or dodging income tax; we are simply controlling the narrative. Why spend a bunch of resources to prove your innocence (unless you’re O.J.)?

By Jason Watson, CPA
Posted Friday, October 20, 2023

A simpler way to accomplish the same thing as above is to create three entities again, but the multi-member LLC is owned by you (the humans) and the other guys, not the S corporations. While we showed the previous schematic, the following is the preferred arrangement for a host of reasons, especially state apportionment of income and business valuation (more on that in a bit).

The S Corps issue consultation, fee for service or management fee invoices to the multi-member LLC in the amount of the net business income (profits) split driving the multi-member LLC income down to zero, or some nominal amount like $500. In other words, the payments from the MMLLC to the S Corp would be recorded as Payments for Services Rendered or Outside Contractor or something similar (see dotted lines below).

Therefore, each human would receive two K-1s. One from the MMLLC or “mothership” for a small amount and another from his or her respective S Corp. Additionally, this still accomplishes the Eat What You Kill income splitting objectives and changes the color of money through distributions from each person’s “baby” S Corp. Flexibility plus tax efficiency. Brilliant!

This would also be beneficial if you didn’t have an Operating Agreement or if you are afraid that an Operating Agreement could be too restrictive from year to year. You would still need some sort of instrument or agreement that dictated how the fees are calculated so there aren’t any hard feelings.

Regulated Industries

The above schematic is also preferred for regulated industries like financial advisors or real estate agents where entity ownership must be individuals. In some states and with certain regulatory agencies, the MMLLC may be owned by S corporations provided the named principals are the licensed / regulated individuals… again, this arrangement avoids that issue.

Having said that, the “baby” S Corps typically must register separately with their regulatory body. For example, if you are band of attorneys wanting the mothership baby S Corp multi-entity construct (yeah, we just made that up) with fee for service agreements, each S Corp would probably need to be registered as a law office with the state bar. This is a minor housekeeping detail, but an important one.

State Income Tax Footprint

You might also reduce your exposure to state nexus based on revenue or income. If the MMLLC is a California entity issuing a small K-1 to an individual running an S Corp in Illinois, you will reduce the long-reach risk of California. What do we mean here?

Scenario 1 is where your Illinois S Corp owns member interest in a California LLC. The LLC will issue a K-1 to your S Corp and now you instantly have a very visible tax footprint in California. They will likely be expecting a state tax return for your Illinois entity doing business (as they see it) in California.

Scenario 2 is where your Illinois S Corp provides a service to a California LLC in a business to business (B2B) relationship. You might still have a tax footprint in California, but you are in complete control of the narrative since California does not instantly know about this not-so-visible relationship.

We are not advocating avoiding apportionment (the allocation of taxable income to other states), but at least you are more in control of what California knows and what they don’t need to know. They feel like they need to know everything, and they most certainly do not.

No 1099s

Do not issue 1099s in this scenario. First, a 1099 is only required to be sent to non-corporations. Even though you might have created an LLC and then later elected S Corp status, you are now considered a corporation for taxation and your vendors are not required to send you a 1099 (although many do).

Side Bar: Business tax returns such as Form 1065, 1120 and 1120S are usually prepared by tax professionals, and as such the IRS believes revenue has a much higher chance of being recorded properly, and 1099s are not necessary. It would also be ridiculous for Verizon to receive a million 1099s from its customers. Funny, Yes, but ridiculous.

Second, a 1099 has EINs and possibly SSNs. Since these dots can be connected by the IRS, the issuance of a 1099 might invite unnecessary scrutiny. The IRS agent’s question becomes “Why did you issue a 1099 to a partner rather than let the income flow through a K-1?” “To avoid taxes and headaches” is probably not going to go well during the audit.

A multi-member LLC with a zero for taxable income (or close to it) is a no harm no foul tax return. In other words, it flies well below the radar but it also above reproach. As stated previously, Fred, Velma and Shaggy would get two K-1s, one from the MMLC and another from their S Corp.

Here is a brief recap of three possibilities given what we’ve discussed in the previous two schematics-

• The mothership (MMLLC) makes distributions to the S Corp members and issues a K-1, both in accordance with the Operating Agreement’s provisions. The S Corps pick up the K-1 as ordinary income plus external income that is earned separately from the MMLLC (moonlighting… or another MMLLC perhaps).

• The mothership pays guaranteed payments to the S Corp members, which fluctuate according to the Operating Agreement’s provisions. The MMLC distributes the remaining cash to the S Corp members and issues a K-1, both in accordance with the Operating Agreement.

• The mothership makes direct payments to the S Corps and are recorded as fees for services. This can be called a corp to corp or business to business transaction. The individuals are the members of the MMLLC, and the external S Corps are recipients of the fees for services.

There are two additional considerations for the mothership baby S Corp construct-

• In California, you might want the mothership to be taxed as an S corporation to avoid the franchise tax being calculated on gross receipts. See California Multi-Member LLC S Corp Twist.

• It might be better for the mothership to be a C corporation rather than an LLC. There are some concerns with a member of an LLC being paid as a contractor to provide services that he or she would otherwise be required to provide to the LLC in a fiduciary capacity. There are other benefits of a C Corp as well. See C Corporation as Mothership.

By Jason Watson, CPA
Posted Friday, October 20, 2023

Alright… we just explored some of the pains in the butts with a multi-entity structure. Let’s recap the benefits so you can value-assess the pros and cons.

Eat What You Kill

Some people soften this phrase to Eat What You Hunt. It makes no difference to us… the end result is the same. Someone’s eating, right? You want to ensure your efforts are rewarded appropriately however that is defined or calculated. A multi-entity arrangement allows for that while keeping your ownership percentage static. As mentioned previously, you can make tweaks with shareholder salaries to equalize or to provide an equitable outcome. Unfortunately, salaries can only do minor equalization tweaks without paying too much in Social Security and Medicare taxes.

Expenses and Fringe Benefits

You and your partner want to buy automobiles. Great! How much are we spending? Perhaps you want a small economic sedan and your partner wants the latest Ford-a-saurus. Sure, you could put a limit on the purchase amount where anything above that the partner or owner has to pay for separately. But what about maintenance? Or finance charges? Or registration fees? These additional expenses might be contingent on value.

Aside from automobiles, there are other fringe benefits that might be challenging. Partner A wants to insure his whole family. Partner B doesn’t need insurance. Partner A wants to buy a work laptop for home. Partner B already has a home setup. The list goes on and on, like a Journey song.

Having a multi-entity structure keeps fringe benefits from becoming political hot potatoes around the office.

Reimbursements

Along the lines of fringe benefits comes reimbursements, and specifically Accountable Plan reimbursements (which we discuss in detail in a later chapter). Let’s say your home office is 250 square feet and your home is 2,500 square feet. That is 10% business use. But your partner lives in an apartment, and her business use percentage is 25%. But! You have a mortgage and property taxes, whereas your partner pays rent. How do we keep that equitable? Tough!

Similar to automobiles, we can establish a not-to-exceed reimbursement limit but doesn’t that hose the owner who has more expenses? It certainly does.

Office Politics

You fly first class and your partner slums it in economy. You want a new computer and your partner thinks a 486 is still the best. And if you know what a 486 is then you are certainly a product of the 90s. A multi-entity structure doesn’t necessarily solve all office politics, but it takes away some of the sting since you can spend what you want and get the maximum tax benefit without being crimped by your partner.

Apportionment

As mentioned earlier, if your business activities including the locations of the owners span multiple states, a multi-entity arrangement will allow for less state scrutiny. Yes, you will pay your fair share of income taxes to each state that you have nexus in, but the states will have limited visibility into your world without requesting an audit. Why give them something to bother themselves with unnecessarily?

We expand on this next.

By Jason Watson, CPA
Posted Thursday, October 19, 2023

Another thought along these lines involves a multi-member LLC where you and another non-spouse partner are the members. Later in another chapter you’ll learn that one of the limitations of an S corporation is that distributions must be made in the same percentage as ownership. So, if you are 50-50 with another S Corp shareholder, distributions must also be 50-50.

For now, let’s backup for a moment. If this multi-member LLC was not taxed as an S corporation, the Operating Agreement could dictate a different schedule of distributions (we call this special allocation under Section 704). For example, you and another insurance agent team up. But you want an Eat What You Kill revenue model. In this case, you could be 50-50 partners from an ownership perspective, but have the splitting (sharing) of net ordinary business income after expenses and deductions (the profit), and eventual distributions fluctuate based on the production of each insurance agent. Elegant. Simple.

You S Corp elect this thing, and now it blows up. Regardless of the production or income splitting is detailed in your Operating Agreement, or whatever, distributions must be 50-50 since that is the ownership percentage among the two shareholders. Said in another way, the net business income is assigned to each shareholder purely based on ownership percentages and cannot be changed easily.

You could always abandon the S corporation election idea, but you are a taxpaying citizen and want the best of both worlds. You want to save on self-employment taxes as well as having a fluctuating income split. What can be done?

The first solution is to equalize with salaries. Let’s say the revenue split based on production for the current year should be 55-45 but you are 50-50 owners. Salaries could be adjusted so that the “55% earner” obtains more of the available cash. This is an easy solution and works reasonably well when the net business income split closely resembles the ownership (or distribution) split.

But if the divergence between net business income and ownership grows too much then equalizing through salaries becomes problematic since the increase in salary for the “high earner” becomes too expensive; keep in mind, and we will reiterate this again later, every $10,000 in salary costs about $1,500 in payroll taxes. Therefore, if an unnecessarily high salary is needed to equalize net business income splits between S Corp owners you might be paying too much in payroll taxes.

Here is an example-

In this example, there was $200,000 in profits before shareholder salaries and distributions. Robin needs to get paid $120,000 in some fashion because of a production formula with Batman and the business (let’s say they are financial advisors). Salaries were set at $76,000 combined. However, to provide an economic benefit of $120,000 to Robin between salary and distributions, a $40,000 bonus needs to be paid. This creates $6,120 in unnecessary taxes that the business has to pay because of the combination of S Corp rigidity and production-based profit split.

What’s plan B then? Easy!

We create three entities. A holding company that is a multi-member LLC (MMLLC), with each member being an S corporation. Each S corporation is owned 100% by each principal involved. Stay with us on this one. The following example shows three S corporations as members of the MMLLC, but just ignore one side if you are a two-person show.

The MMLLC is really a funnel. All revenue goes in, all common expenses are paid out such as internet, copier lease, admin functions, etc., and an Operating Agreement dictates how the distributions are to be handled. K-1s are issued to the members which happen to be S corporations. And then those S corporations pay a reasonable salary to its respective sole shareholder and distribute the remainder.

Let’s break this down with an example. $250,000 is earned by the MMLLC after expenses. S Corp 1 receives $125,000 according to the Operating Agreement (yet it remains a 1/3 owner). S Corp 1 pays out a reasonable salary of $55,000 and distributes $70,000. S Corp 2 receives $60,000 and S Corp 3 receives the balance… and both S corporations pay out a reasonable salary and distribute the remainder.

There are some excellent benefits with this arrangement beyond the income splitting and saving of self-employment taxes. Each S corporation is independent, and has autonomy and privacy. In referencing the previous schematic, there are some intangible yet valuable tax advantages-

• Fred could buy whatever business car he wanted. Sure, the MMLLC could establish an allowance that everyone is allowed to spend, and any amount about that is augmented by the members but that gets messy real quick and loses significant tax efficiency.

• Velma could work from home and reimburse herself for a home office while others choose not to. Also, consider that Fred and Velma might have different sized home offices and associated expenses, and by leveraging the reimbursement at the S Corps level, you remove office politics and equalization issues.

• Shaggy could rent an office since his place is… well… a doghouse of sorts and he needs some space to work.

Each S corporation can run expenses through as it sees fit without upsetting the other business partners. For example, you want to attend conferences in Las Vegas. Another example would be adding a child or spouse to payroll. Each S Corp operates independently and can do what it wants with its money (with some minor rules such as 401k plans). Home office? Buy a car?

We see this arrangement commonly in attorneys, medical groups (surgery groups, physicians, doctors, anesthesiologists, nurse anesthetists, etc.), insurance agents and financial advisors. It is very common in entities where the net business income is not shared equally, but rather on some formula or agreement.

401k plans in this situation are tough since it is a controlled group (technically what ERISA and the IRS call an Affiliated Service Group). More information can be found in a later chapter on controlled groups, and how retirement planning within this scheme works. This is a commonly overlooked problem with this arrangement; proceed with caution with your 401k plan administrator (spoiler alert: you can have separate 401k plans if you have only owner employees).

Wait! Before you blast off and create the above arrangement, this has fallen out of favor. There is another version of this where the MMLLC is owned by the individuals rather than the S corporations. Why? Let’s find out!

By Jason Watson, CPA
Posted Thursday, October 19, 2023

This is one of the most common situations where you own two entities that conduct business between themselves. For example, you are a typical poor accounting firm with the usual high maintenance clients, and you feel that everything would be better if you also owned your own office building. You would create an LLC as the real estate holding company which owns the building, and another LLC (and probably taxed as an S Corp) for the operating company.

This allows for some excellent ownership separation. For example, if you and your father-in-law own the building, he doesn’t have a stake in your accounting firm, and vise-versa (didn’t we just scare you with this idea, and now we are bringing it up as an example… we’re evil). You might also want to make one of your key employees a business partner in your operations, but he or she should not have a stake in the building. Chinese Wall. Can we use Chinese Wall as a separation analogy anymore? We likely offended someone.Please keep in mind that rental properties including self-rentals are mostly wealth-building strategies and not tax reduction strategies. Yes, depreciation and perhaps even cost segregation can yield some accelerated tax savings, but even that is primarily a wealth-building move.

The holding company and operating company arrangement can also reduce self-employment taxes or payroll taxes since this conduit changes the color of money. Huh? As discussed in an earlier chapter, your accounting firm’s income is earned income, taxed both at the self-employment tax level (or payroll tax level) and the income tax level. However, you reduce this earned income by the amount of rental expense and that subsequent rental income on the other end is considered passive and only taxed at the income tax level (technically non-passive since it is a self-rental under Section 469, but let’s not muddy the waters).

Beauty! You must have a lease and the rent must be market rates; usually a rent appraisal from an independent appraiser will suffice. The rent appraisal is also a good idea in the expansion of ownership. For example, Jason and Tina Watson own the building that WCG leases. As WCG expands its ownership to other partners, the rent payment to Jason and Tina needs to be above reproach; ergo, a rent appraisal. This reduces office politics and hurt feelings. Maybe just office politics.

By Jason Watson, CPA
Posted Saturday, October 21, 2023

WCG CPAs & Advisors has implemented the poor man’s version of an ESOP where our primary entity is a C corporation which has a robust Shareholder Agreement for buying and selling of shares. Why do you need a Shareholder Agreement? If you own 5% of a privately held small business, you basically own 0%. Huh?

Unless there is a market (public or private) where the minority shareholder can sell his or her shares, a 5% ownership in a privately held small business is not marketable and therefore not as valuable. In the business valuation world we call this degradation of value a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM).

Therefore, a business needs to create a market both on the buy and sell side. For example, CPA firms typically are valued at about 1.0 to 1.2 times gross revenue depending on the book of business quality (age of clientele, average fee, amount of recurring revenue, etc.). Using our example, you could set up a program where an employee could buy shares using a valuation formula. Let’s say you have a CPA firm and you believe the multiple is 1.2, and you also want to give your employees a 10% discount. You are growing and so you also want to use an average revenue number based on the previous two years to smooth out the value.

Your per share value formula would be (90% x Avg Revenue x 1.2) / number of issued shares. This could be used for the buy side, and on the sell side.

On the buy side you could allow employees to purchase shares annually. You could also issue shares as a form of compensation (yes, that would find its way onto a W-2). You could also use this arrangement for a future owner where he or she pays some cash and obtains bank financing for the remainder allowing acquisition of a large chunk of shares. Many business-oriented banks will put together a deal where the new owner puts in 20% and the bank finances the 80% using the original owners as a backstop for collateralization. In other words, the sellers or original owners would promise to buy the shares back from the bank upon default, should it occur. You might have to post collateral to satisfy the bank’s risk department.

On the sell side you could allow employees to sell annually as well, and only upon separation from the business. By creating a market, a 5% minority ownership now has value. Some other considerations include that no person or entity other than current employees can own shares, and should an employee get divorced he or she cannot give the marital property to the other spouse.

Another consideration is voting rights. Do the minority shareholders have a vote? Perhaps by proxy? Ownership without a voice might not feel like ownership to your employees. How about wholesale sale? In other words, are the majority owners allowed to sell the entire business including the employees’ interests (usually Yes, through drag along rights)? Do the employees get a first right of refusal to buy out the majority owners?

Our example above was straightforward since CPA firms have enough market data to determine a gross revenue or sales multiple. Other businesses use multiples as well such as insurance agencies, financial advisor firms, franchised restaurants among several others. If a market approach to valuation using a gross revenue or sales factor cannot be used, a more complicated valuation approach or agreed-upon formula must be used.

How does the current owner(s) pull money out? Our schematic illustrates an arrangement that could be followed.

In our arrangement, income flows into the C corporation which is owned by you and your employees. A contractual arrangement would exist where the C Corp would pay your S Corp a management fee leaving a small amount of C corporation income behind (near zero).

A minor thorn to this arrangement is the accumulation of working capital at the C Corp level. As a business grows, it will need increased working capital. At WCG we peg that to be 5% of the current year’s revenue. Whenever you grow working capital, you will pay taxes on the growth since the money is left behind in the C Corp and not paid out as a fee for service to the S Corps.

This is a generalization and proper consultation with a tax professional (us) and an attorney (others) is a must. Under current SEC laws, such as Regulation D, and Colorado Securities laws, WCG does not have to register our stock as a regulated security. Your state might be different.

By Jason Watson, CPA
Posted Tuesday, July 6, 2021

You might have two business entities, and you want to combine them but they are also very different. For example, you are a realtor and your spouse is an IT consultant. We could create a holding LLC called Smith Ventures which owns the realtor LLC and the IT consultant LLC. In other words, the realtor LLC and IT consultant LLC have a single-member, and that single-member is the holding LLC.

The holding LLC would then make the S Corp election, and all the LLC income (realtor and IT, using the example above) would flow into the S corporation as wholly owned subsidiaries. Remember, single-member LLCs are disregarded entities and are reported on the sole member’s tax return. In this case the sole member is a sexy and tax-efficient S corporation. Sexy and tax-efficient… probably went too far with that one. The again it is called an S Corp election for a reason, and not a U Corp election.

You might be saying, “Yeah, but, why not just have two S Corps?” You can, and in some situations you must (like an attorney and doctor as a married couple). The downside is the additional costs in tax return preparation and payroll processing. Conversely in the arrangement above, all the payroll for the shareholders is handled out of a single S Corp. Each single-member LLC (SMLLC) is a disregarded entity and therefore only a singular tax return is required at the S corporation level.

We rattled that off fairly quickly. Let’s break it down with some specifics. An S corporation tax return preparation fee is generally $1,500 to $1,800, and the cost of processing shareholder payroll is about $1,200 annually. Let’s call this $3,000. By having two S Corps, you added $3,000 to your overall legal and professional services budget perhaps unnecessarily. Then again if a little division between you and your spouse keeps the pillow talk on the positive side, then perhaps $3,000 is cheap therapy.

Another benefit is that one of these business units, subsidiaries or whatever you want to call them can be carved away and later sold off. You could also expand ownership in one without expanding ownership in the whole structure (we’ll show this later in the chapter).

Let’s move onto the minor inconveniences. Each entity should have its own checking account and set of books. Common expenses such as an umbrella policy or tax preparation fees would be paid at the S corporation level, while subsidiary-specific expenses such as website hosting would be paid at the LLC level.

Also, if you want to take a distribution out of one of the subsidiaries, truly the S corporation would receive the distribution first, and then make another distribution to you, the shareholder. A double hop, and what is referred to as a trampoline in the drug trafficking business (fire up Narcos or Snowfall… great shows!). In other words, transfer money from the SMLLC’s checking account to the S corporation’s checking account to your checking account. Please don’t take it directly from the subsidiary.

Another inconvenience is that each entity might be slapped with high annual fees from the state in the form of filing fees, or franchise taxes (like California) or both. For example, if this arrangement was in California, there would be a minimum of $800 x 3 in franchise taxes. Nasty! The benefits might still outweigh the costs but be careful.

This is a common strategy between husband and wife teams where the business entities are completely different, yet the household wants to enjoy the benefits of an S corporation.

Side Bar: We must analyze limitations in each of the subsidiary LLCs. For example, you cannot have an LLC that would be deemed a hobby tucked under the “protection” of an S Corp. Each LLC must have a profit motive. There might be other limitations at the LLC level, but the hobby loss limitation is a wonderful illustrative point.

Want another? Section 199A Qualified Business Income Deduction has limitations for Specified Service Trades or Businesses (SSTB). Therefore, if one SMLLC is deemed an SSTB and another SMLLC is not, there will be some extra math calculations in determining the Section 199A deduction.

Expanding Ownership

Expanding ownership will be discussed in more detail in a later chapter, but we quickly wanted to add some more reasons for the compartmentalization of your multiple business units into LLCs. Let’s say you have a home inspection business and a home remodel business. Like the real estate holding company / operating company arrangement, you might want to expand ownership in the remodeling business unit and not the inspection business unit.

For example, you add a partner to the home remodeling LLC and it suddenly becomes a multi-member LLC (the MMLLC above). This entity would have two members; your S corporation and the other guy. The other guy could be an S corporation as well. In this schematic you would need two business entity tax returns; a Form 1120S for the wholly owned S Corp and a Form 1065 for the MMLLC (Partnership Tax Return). Your S Corp would receive a K-1 from the MMLLC.

A Twist

You could also have the SMLLCs remain owned by each spouse individually. The SMLLCs could then pay the S Corp for services rendered, like a management fee, driving the SMLLC income down to a nominal amount, like $500. Why?

401k plans have all kinds of rules on controlled groups and discrimination rules, and we’ll explore more of that later in another chapter. However, if husband owns SMLLC “A” and wife owns SMLLC “B,” each business can have a separate 401k plan. One could be filled with employees, and the other is just a solo 401k plan. This is provided that the spouses don’t participate in each other’s business (again, more on this narrow exception to controlled group rules in a bit).

We discuss holding companies and management companies, and how they are different, later in this chapter.