Here is a tax strategy – set up a C-Corporation and have your existing corporation or LLC pay it a management fee. Have you heard this tune before? It’s surprising how many entity mills use this tired old logic to reduce taxes for an existing business and its owner. Most of these strategies come from groups located primarily in Nevada or Wyoming who masquerade as legal firms when in reality they are just a sales organizations that lack any true understanding of what it takes to create this type of relationship and have it respected by the IRS. A tax court case late last year addressed this issue when confronting whether a corporation set up by a taxpayer to provide management fees to his other entities is reasonable. The IRS originally challenged the payments as being unreasonable namely because the fee was contingent upon the profit made by the other companies and was far above what unrelated companies would charge for similar services. The Court, in evaluating the business setup did not take issue with the taxpayer’s creation of a management corporation rather it looked at how the management fee was determined by the taxpayer. In finding for the Service, the Court held the fee was unreasonable and should be adjusted downward.
When entering into these types of arrangements one should consider whether there is a bona fide business purpose for the transaction such as limiting liability for management, centralizing the collection of rents from multiple rental LLCs, minimizing accounting and bookkeeping costs, or providing a service typically provided by third-party entities. After you establish the business purpose for the management entity then you should document any third parties you research to justify your management fee. For example, if my corporation was managing my rental real estate LLCs and the corporation agreed to provide the blow referenced services to each LLC (you would specify this in your management agreement) I would ask other leasing companies what they would charge for similar service and set my fee accordingly:
- Lease the property
- Management the tenants
- Collect rents
- Pay all bills, mortgages, and taxes
- Make repairs as needed to the property
- Perform annual market valuations for setting rents
- Actively market and promote the property
Management companies can be a valuable tax planning tool, but you do not want it to appear that tax reduction was your primary motivation in creating the structure. Hastily put together structures without the backup documentation to justify its existence will make it difficult to defend in an audit.