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Editorial 8 MIN READ

Layering a holding company in April 2018: the only ways to avoid double tax

Pick the wrapper that passes dividends upstream at a zero rate, or pass-through them entirely

The Editors
Staff, Incorporator.org
8 min read Updated
Contents 8 sections
  1. The double-tax problem, in one paragraph
  2. The dividends-received deduction after TCJA
  3. The consolidated return: the same 80% test, a different mechanism
  4. The LLC-over-LLC stack: no dividend, no double tax
  5. Mixed stacks, and where they go wrong
  6. Check-the-box as a design tool
  7. Rule of thumb
  8. Sources

holding company that owns an operating company can be taxed twice on the same dollar, once at the sub and again at the parent, unless the stack is built to prevent it. In April 2018, there are three builds that prevent it cleanly: a C-corp parent holding 80% or more of a C-corp sub (100% dividends-received deduction under IRC § 243), a C-corp parent holding 20% to 80% of a sub (65% DRD under the new TCJA rates), or an LLC-over-LLC pass-through stack that never produces a dividend in the first place.

Readers who came in asking "will I get taxed twice if I put a holding company on top" are asking the right question. The answer depends on which wrapper sits at each layer and how much of the sub the parent owns. Under the holding company structures primer we have already walked the shapes. This piece is the math.

The double-tax problem, in one paragraph

A C-corp pays tax at the corporate rate on its profits, then its shareholders pay tax again when the after-tax profits come out as dividends. Post-TCJA, the corporate rate is a flat 21% under new IRC § 11(b) (Pub. L. 115-97, § 13001, enacted December 22, 2017, effective for tax years beginning after December 31, 2017). Qualified dividends to individuals still top out at 20% plus the 3.8% net investment income tax. Two layers of operating C-corps, with a dividend crossing between them, would ordinarily import that same problem inside the corporate stack: the sub would pay 21%, distribute cash to the parent, and the parent would pay 21% again before the eventual shareholder distribution. The Internal Revenue Code has a carve-out precisely so this does not happen. It is called the dividends-received deduction.

The dividends-received deduction after TCJA

IRC § 243, as amended by the Tax Cuts and Jobs Act, lets a C-corp shareholder of another C-corp deduct a percentage of dividends it receives, and the percentage scales with ownership.

Under the pre-TCJA version of § 243, the tiers were 70% for corporate shareholders owning less than 20%, 80% for 20%-to-80% ownership, and 100% for affiliated-group members owning 80% or more. TCJA (Pub. L. 115-97, § 13002) reduced the two lower tiers and left the 100% tier intact. Effective for tax years beginning after December 31, 2017, the percentages are:

  • 50% DRD when the recipient corporation owns less than 20% of the payor (IRC § 243(a)(1), as amended).
  • 65% DRD when the recipient owns 20% or more but less than 80% (IRC § 243(c), as amended).
  • 100% DRD when the dividend is a "qualifying dividend" from a member of the same affiliated group under IRC § 243(a)(3) and (b)(1), which cross-references § 1504(a) for the 80% vote-and-value affiliated-group test.

TCJA pulled the lower two tiers down so that, combined with the new 21% corporate rate, the effective tax on an intercorporate dividend is roughly the same as under prior law. Under the old numbers, a 70% DRD against a 35% corporate rate produced a 10.5% residual rate on an under-20% intercorporate dividend; under the new numbers, a 50% DRD against a 21% rate produces a 10.5% residual. The tiers moved; the burden did not.

The 80% tier is where the architecture happens. If a C-corp parent owns at least 80% of the voting power and 80% of the total value of a C-corp sub, the sub can distribute its after-tax profits up to the parent without the parent owing a second layer of corporate tax. That is the structural condition the tax code rewards. Below 80%, the residual bites at every upward dividend.

The consolidated return: the same 80% test, a different mechanism

If the 80% affiliated-group test is met, the group has a second, more powerful option: filing a single federal consolidated return under IRC §§ 1501 through 1504. Consolidation goes beyond the DRD: it eliminates the intercompany dividend from the group's taxable income entirely (Treas. Reg. § 1.1502-13(f)(2)), lets losses from one member offset income of another in the same year, and defers gain on intercompany sales of property until the property leaves the group.

The price of consolidation is real. Treas. Reg. § 1.1502-13, the intercompany-transaction regulations, requires matching and acceleration rules that the selling member and the buying member must track together across years. Losses brought in from outside the group are subject to Separate Return Limitation Year (SRLY) limits. The election, once made on Form 1122 for each first-year consolidating sub, generally cannot be reversed without the Commissioner's consent (Treas. Reg. § 1.1502-75(c)).

The affiliated-group definition in IRC § 1504(a)(2) is identical to the top DRD tier: a common parent corporation that directly owns stock meeting both an 80% voting-power test and an 80% total-value test in at least one includible corporation, and each other includible corporation is 80%-owned by one or more corporations in the group. Stock for this purpose excludes preferred stock of the type described in § 1504(a)(4), which keeps pure preferred instruments from gumming up the ownership count.

For a C-corp holding structure where the parent actually controls each sub, consolidation is usually better than relying on the 100% DRD. It nets current-year losses, which DRD alone cannot do, and it eliminates intercompany dividend paperwork at the return level.

The LLC-over-LLC stack: no dividend, no double tax

The cleanest way to avoid double tax is not to produce a dividend at all. An LLC that has not elected C-corp treatment is either a disregarded entity (one owner) or a partnership (two or more owners) under Treas. Reg. § 301.7701-3 (the check-the-box regulations). Income flows straight through to the owner. Nothing is taxed at the entity.

Stack this twice and the structure collapses, for federal tax purposes, into something simple. A single-member LLC parent that wholly owns three single-member LLC subs is, to the IRS, one taxpayer reporting on one Schedule C (for an individual owner) or inside one consolidated corporate return (for a corporate owner). Each sub is disregarded; the parent is disregarded; everything is the grandparent. State-law liability separation is preserved. Federal tax compliance is one return.

If the parent LLC has two or more members, it files Form 1065 as a partnership and issues K-1s upward. Wholly owned LLC subs below the partnership are still disregarded under § 301.7701-3, so the partnership books the subs' operating activity directly. The result is one partnership return up top, several state-level LLCs below, and no entity-level federal tax anywhere in the stack.

TCJA's § 199A pass-through deduction (IRC § 199A, added by Pub. L. 115-97, § 11011) rides through this structure. The 20% qualified business income deduction, subject to the W-2/UBIA limitations and the specified-service trade-or-business phaseouts, is computed at the owner level, not at the LLC level. An individual owner of an LLC-over-LLC stack claims § 199A on the aggregated QBI that flows up, with one caveat: § 199A aggregation rules (still in proposed-reg territory as of April 2018; the Treasury has indicated guidance is coming) govern when multiple flow-through businesses can be combined for the W-2 and UBIA tests. Owners with multiple operating subs should assume aggregation matters and document the relatedness tests now rather than reconstruct them at return time.

Mixed stacks, and where they go wrong

Real structures are rarely pure. A C-corp parent may hold some C-corp subs and some LLC subs. An LLC parent may hold a C-corp sub that produces qualified small business stock. Mixing is fine; mixing without knowing which cell has which rules is not.

A C-corp parent that owns a pass-through LLC sub is allocated the LLC's income as ordinary trade-or-business income on the parent's Form 1120. There is no dividend, so there is no DRD question; the LLC's income is simply the C-corp's income. The 21% corporate rate applies. No pass-through deduction is available because § 199A applies only to non-corporate taxpayers (IRC § 199A(a)). This is why, under TCJA, putting pass-through operating activity under a C-corp parent is usually the wrong move for an owner who could otherwise hold the LLC directly and claim 199A.

An LLC parent that owns a C-corp sub gets the worst of the other direction. The C-corp sub pays 21% on its profits; when it distributes to the LLC parent, the distribution is a dividend. The LLC parent is not a corporation, so it cannot claim § 243 DRD (the DRD is available only to corporations under § 243(a)). The dividend passes through the LLC partnership to the ultimate individual owners and is taxed at the qualified-dividend rate, if the holding period is met, or at ordinary rates if not. Effective total burden: 21% at the corporate level plus 23.8% at the individual level, roughly 39.8% on the combined distribution. Two layers, full double tax.

The single most common mistake in mixed stacks is exactly that one: putting a pass-through parent over a C-corp sub because "an LLC is simpler," then distributing cash upward and discovering that the simplicity evaporates in the tax table. If the bottom is a C-corp, the top should usually be a C-corp, and the top should usually own 80% of the bottom.

Check-the-box as a design tool

The check-the-box regulations (Treas. Reg. § 301.7701-3) are the quiet hinge of the whole structure. A wholly owned LLC can, by filing Form 8832, elect to be treated as a corporation for federal tax purposes; a corporate sub cannot elect to be disregarded (once a per-se or electing corporation, always a corporation for this purpose, absent a liquidation). This one-way ratchet matters when you are designing a stack from scratch.

A conservative build for an operator who wants optionality: form the parent as an LLC, form each sub as an LLC, and elect C-corp treatment only on the entity that actually needs it (typically the one holding C-corp stock, taking institutional investment, or pursuing IRC § 1202 qualified small business stock treatment). The LLC default is disregarded or partnership; the C-corp election is available by Form 8832 whenever the business case arrives. The reverse (un-electing a C-corp once it is in place) is a taxable liquidation under IRC § 331 and is rarely what anyone wants.

Rule of thumb

If every wrapper in the stack is a pass-through LLC, double tax is structurally impossible; if any wrapper in the stack is a C-corp, the parent above it must either own 80% of its vote and value (for 100% DRD or consolidation) or accept that every upward dollar is taxed twice.

Sources

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