What It Takes To LEGALLY Upstream Income (And Why You Need to Know This)
One of the tax planning tools that has been around for years (decades) is the technique of “upstreaming.” I first learned about it right out of college in Reno, NV. At that time there were a lot of California business owners who were fed up with the high state income taxes and wanted to find legal alternatives. They wanted to upstream income to Nevada.
That was a few decades ago (yes, I have been a Tax Strategist that long) and not much has changed. But the bad information has become more and more prolific and I’ve found, over the years, that my information has been ripped off again and again. In fact, I had someone recently send me an email at Diane@DKTaxServices.com to ask how my program was different than another guys. It was EXACTLY like mine was - only 8 years old. That’s because this guy had been a client back then, had a strategy and then duplicated the advice I gave him again and again. Well, he has one strategy and only one, and he’s doing like we did 8 years ago. A lot has changed in that time.
Upstreaming income is a solid technique, provided you do it right. And right now there are a lot of tax advisors out there giving bad advice.
Why upstream? Let’s start there. You can upstream from one company to another that is domiciled and has nexus in another state. If it’s a C Corporation, you won’t pay your home state income tax. Another technique is to divide out the multiple streams of income you have in your company to separate out the active income from the passive income. (This is one that I personally do) You might want to upstream income to legitimize an asset protection plan where you have separated out tangible and/or intangible assets. Or you might want to upstream to another company to take advantage of a separate tax structure (corporate as well as individual). Or you might want to upstream to another company that has been set up to flunk controlled group issues so you can have nondiscriminatory benefits without having to include other employees of the first company.
Upstreaming is a fantastic tax strategy, in the right hands. You need to prove economic substance. In other words: Why upstream? Is there a reason for this strategy other than you want to pay less tax? Right now we are required to provide economic substance, but the definition is more subjective. One of the changes that Pres-Elect Obama wants to make is to create a codified (ie, specifically in the law) definition of what economic substance is. This could be a big issue in the future. We’re already planning for it right now, and assuming it will happen, with the tax strategies that we set up. (That way our clients won’t get caught unaware.)
You also need to have the right corporate documents to provide an audit trail for the strategy. For example, let’s say that you have a doctor with fixed assets in her practice. She wants to move those out to another entity for asset protection reasons. Then she realizes she can provide some nice benefit plans provided an unrelated party owns the 2nd entity. In this case, we needed to use Agreement # 7 Membership Interest Transfer Restriction, Agreement #34 Equipment Lease Agreement and Agreement# 29 Sale of Business Assets.
This will protect the doctor in case something happens with the ownership of the 2nd entity (ie, the owner flakes on her and she wants to get the assets back) and establishes economic substance by providing a clear trail for the sale of business assets and the resulting lease back.
The Agreements and their numbers are part of Megan’s secret cache of agreements - “97 Agreements Your Business Can’t Live Without.”
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So I have a consulting company which runs under an LLC. All of my business activities are done through this LLC. This LLC is classified as a partnership between myself and my partner. Over time, we had purchased a couple of investment properties through the LLC while running the existing consulting business within. So naturally the income and expense activities for the investment properties were done through the LLC as well.
After a year or two, we decided to move the properties from the 1st LLC to another 2nd LLC to at least prevent liabilities between the business and the assets of the company. In addition,the purpose of the 2nd LLC was to manage the existing real estate assets and future investments to be made by the 1st LLC.
Is it possible to pay the 2nd LLC an asset management services fee from the 1st LLC? I was tasked to manage the assets in the 2nd LLC in which my partner and I are also an owner. However, in the 2nd LLC operating agreement, I’ve got a higher share on the distribution of income in the 2nd LLC due to my active responsibility of managing the 1st LLC real estate assets and investments. I have spent a lot of time and energy on the real estate mgmt and stock management activities. Will I be able declare my service fee as a consultant working in the 2nd LLC to manage these activities and expense the consulting fee on 1st LLC books?
Is this situation the same idea as “up streaming the income” into another entity? Is this situation valid or am I missing something in order to do this properly? I was reading somewhere that a C corp entity is required in the mix to upstream income properly? Is this true and if not can u please clarify why a C-corp would be necessary or does it even apply to us?
This is a great real-life example of upstreaming.
If there is a legitimate business purpose to having LLC #1 pay LLC #2, then the answer is yes. Make sure you document the agreement and reflect it in minutes for both companies.
You are not required to use a C Corporation in upstreaming. I think a lot of people associate a C Corporation, though, because a C is used when the goal is to use a different tax bracket or pick up more benefits.
One question I had in this, though. Your consulting LLC, taxed as a partnership, will be subject to self-employment tax of 15.3%. Why use an LLC bare? I would think about using a layered structure to avoid the self-employment tax.
I cover that in Business Structures for 2009 and Beyond
You mention an interesting point. Are u suggesting that the 1st LLC elect an S-Corp classification or create a nother S-Corp and included it as a member of the 1st LLC?
We were thinking of the S-CORP strategy for our consulting business for awhile and love the idea that we could reap the benefits of stating a reduced salary so the rest of the unearned income is passed on to the share holders as dividends. However, does one still has to pay taxes on the unearned dividends? When you take into account the additional taxes for the unearned dividends, (what is current dividend tax when we take this unearned income out?) plus the extra work of payroll, plus the extra taxes for things like unemployment, is there really is TAX benefit to being an S-corp. Rather you are really only looking at a liability benefit…I think?. Between myself and my partner our gross income is $150,000 and have a high ratio of consulting expenses which we net 60000 in income a year out of our business. We also have a corporate day job through W2. Will the above strategy help? In reference to the “John Edward” case, i see the benefit where he earns $360000 a year and his business unearned income exceeded $11-15 million from his law practice in 1995-1998 (Hope I got my facts right here…please correct me ?) really allowed his situation to take an advantage of the loophole…I mean tax strategy. In addition, should I also concern myself of the tax law changes around the Self-employment savings in S-corp while Obama in this administration? Do we anticipate this coming sooner than later?
Can our situation reap the same benefits here using a layered structure approach for our 1st LLC? We thought it would be easier to maintain a bare LLC in our situation unless we were able to gross consulting revenue 5X what we have now, it would make sense to do this approach? Let me know if I am out of line or maybe u can show quick example to demonstrate the benefit. I may have missed something in my calculation.
p.s By the way, I love your blogs