Entities are one of the most effective ways to reduce your taxes, which is why many tax strategies use multiple entities.
A couple years ago, a U.S. Tax Court hammered a tax strategy for the use of multiple entities. The main issue was the improper use of the entities.
The case involved a doctor who operated his practice as a sole proprietorship for several years, and then changed the structure. The new structure involved several changes that provided significant tax savings.
Two of the key changes were:
1. Putting the practice in an LLC. The LLC was owned by the doctor and a newly formed corporation (owned by the doctor).
2. Forming another new corporation (owned by the doctor) to provide management services to the LLC.
On the surface, the structure isn’t unusual. It’s not uncommon for a doctor’s practice to outsource its management function, nor is it uncommon for a practice to undergo ownership and entity changes.
The court, however, disregarded the two corporations as separate entities for tax purposes. This had a significant impact on the tax savings because all the income earned by the corporations was attributed to the doctor. At the end of the day, because the corporations were disregarded by the court, the tax result was no different than when the doctor was a sole proprietorship.
What went wrong?
While this was a U.S. Tax Court case, the lessons to be learned are universal.
The main issue the court had with the structure was that the doctor continued business as usual and changes were not made to the business operations to reflect the new structure.
Here are few of the specific findings that the court relied on in its decision:
– Neither corporation ever had employees or paid salaries.
– There was no evidence that the management service corporation ever performed the management services for which it was paid and there was no service agreement in place.
– Neither corporation had assets (other than one corporation having a bank account)
– Neither corporation had day-to-day activity
– Assets were not retitled to / from the LLC
– The doctor continued to bill the insurance companies under his sole proprietorship and not under the LLC
All of the above findings were further aggravated by the fact that neither corporation had office space, a website, a phone listing or advertising of any kind.
The court found that aside from signing documents and transferring money, it was business as usual for the doctor.
Learning from the mistakes of others
One of the most valuable pieces of information in the case was that the court didn’t have an issue with the concept of directing income to a corporation to provide management services or restructuring the ownership of the practice.
This is great news for taxpayers because it says the proper use of multiple entities is perfectly legal. The issue the court had with this particular structure was all in the implementation. The entities failed to perform their day-to-day business activities.
If your company is paying an outside management company $100,000 per year, wouldn’t you insist on having a service contract in place? And, wouldn’t you expect to receive reports and updates on a regular basis from your management company?
That shouldn’t change just because you happen to own both businesses. While it may seem obvious that every entity should have its own business operations, it is often not implemented – just as the case demonstrates.
If you have multiple entities, it’s a good time to review the bu