USA Set up a separate company to process overhead

[NYC Numbers]

One of my clients would like to set up a separate LLC so that all overhead and payroll expenses are managed separate from their industry expenses, is there any reason why they can/cannot do that in terms of GAAP or law in the U.S.?

 

[DrStrangeLove]

I'm a little unclear on the setup your client is proposing. Just FMI, let's suppose your client owns Company A and is proposing setting up Company B.
Is your client want Company B to provide payroll processing services to Company A? So the paychecks to Company A's employees are Company A's checks, but Company B is just handling the paperwork, ledger entries, handing the checks out, etc.?

Or is your client proposing that Company B would pay the employees of Company A itself? So that the paychecks would be Company B's checks instead of Company A's checks?

 

[Kat Maple]

Hi NYC Numbers

As for payroll being done in a separate company, this is exactly what happens if you were to use a PEO ( professional employer organization or also known as employee leasing company). The PEO co-employs your employees with you. You pay the PEO and the PEO pays the employees, handles benefits , handles HR, etc. Difference in your case is your client would use a sister company to do this themselves.

Regards,

Kat

 

[NYC Numbers]

DrSL and Kat,

It is very kind of you to reply.

I will explain: Company A issues contracts with clients but overhead and payroll is not paid by Company A. Instead, Company B pays overhead and payroll for Company A and invoices Company A for the work.

I have considered a PEO but their terms will not work as the client wants to include overhead.

I'm making sure and checking to see if there's any reason why my client could not have Company A issue contracts for work with clients and hire Company B (same owner different EIN) to be in charge of Overhead/payroll. The goal is to keep both companies separate.

 

[DrStrangeLove]

OK, that helps. But I have to ask:

1.) How does Company B make money?
2.) Why would Company A enter into such an arrangement with a separate company in an arm's length transaction?

Let me explain:

For a payroll outsource company, Company B makes money by controlling its expenses. Its prices include an allocated amount it puts toward overhead (and profit, of course, but that's not an important distinction for this discussion). But its actual overhead may be different. So Company B's profits come from the spread between actual costs and allocated charges collected. Likewise, Company A has a reason to be in the transaction: it saves money, in theory, by paying less in charges from Company B than it would incur if it did its own payroll. So the transaction makes sense to me; Company A saves money, and Company B bears a risk that can yield profits.

For a PEO, Company B makes money also by controlling its expenses. It similarly includes allocated amounts in its prices that it puts toward its own overhead. But again, its actual overhead may be different. So Company B is bearing a risk that can yield profits. And again, Company A saves money. It avoids HR costs from recruiting and retaining good employees and weeding out bad employees. So this transaction also makes sense to me.

What your client is proposing...doesn't make sense to me. From what you wrote, Company B will charge its actual overhead to Company A, along with all the payroll costs involved. So how is Company B going to make any money? There's no risk transfer that drives profits. Unless its transfer prices include a profit charge, Company B wouldn't make any money, and profit charges without bearing risk is more than a little squiffy.

And how does Company A save any money? If anything, Company A is going to have to pay for Company B's compliance costs--preparing its statements and taxes, legal costs, etc. These are all costs Company A can avoid if it just keeps in house everything Company B would be doing for it. So why would Company A enter into this kind of arrangement? It also sounds like Company B isn't really a separate economic entity, so I'd worry that GAAP rules would make you consolidate their statements anyway, and tax rules would flag the whole thing on suspicion of being a tax shelter or money laundering arrangement.

Maybe there are facts you've not told that make it make economic sense. Maybe your client is trying to gain a tax advantage or something by making its employees look like they're employed somewhere else. Maybe there's some other kind of sharp practice going on. I can't tell from what you've written. But from what you've said, there's no apparent reason why an arm's length transaction like this would exist between two independent companies.

If this isn't reasonable as an arm's length transaction, then that could mess you up with the IRS (IRC 267/267A and IRC 482 come to mind). And if these two companies are a single economic entity, GAAP rules may require you to combine their statements for reporting purposes anyway. So there's possibly significant downside here without any obvious upside. Maybe I'm missing it, but I don't see it in what you wrote.

So I'd ask your client some hard questions about the purpose behind this structure, if only so you don't get hemmed up for it.

Sorry for the long-winded answer. But your description makes me think it's not allowed or it's a bad idea for some good legal reason.

 

[NYC Numbers]

Dr SL,

Wow, I cannot thank you enough for your reply.

All companies owned by this client are LLCs and are owned by a single partner. The goal to save on overhead and staff expenses.

Company A (is in fact Company A1, A2 and A3) these three companies issue different contracts to clients for different service therefore all companies have different industry expenses (We will not move the industry expenses to Company B) and volume of work. In addition, there's only one staff pool (reception, assistant, accounting, etc) doing all of the overhead work. It seems cost effective not to have to set up and pay different payroll companies since Company (A1, A2, A3) do not generate enough revenue and/volume of work to have their own payroll accounts or overhead expenses. So, my client asked if we can set up a Company B that can manage all of the Overhead and Payroll for Company A1, A2 & A3. Company B's revenue will be a 20% management fee on ALL costs. In this way, the owner will save on overhead/payroll expenses.

I made a worksheet, and between companies A1-A3 and the savings is substantial to warrant setting up a separate management entity, but if it violates an IRS ruling, we don't want to do it.

Thank you!

 

[DrStrangeLove]

Dr SL,

Wow, I cannot thank you enough for your reply.

All companies owned by this client are LLCs and are owned by a single partner. The goal to save on overhead and staff expenses.

Company A (is in fact Company A1, A2 and A3) these three companies issue different contracts to clients for different service therefore all companies have different industry expenses (We will not move the industry expenses to Company B) and volume of work. In addition, there's only one staff pool (reception, assistant, accounting, etc) doing all of the overhead work. It seems cost effective not to have to set up and pay different payroll companies since Company (A1, A2, A3) do not generate enough revenue and/volume of work to have their own payroll accounts or overhead expenses. So, my client asked if we can set up a Company B that can manage all of the Overhead and Payroll for Company A1, A2 & A3. Company B's revenue will be a 20% management fee on ALL costs. In this way, the owner will save on overhead/payroll expenses.

I made a worksheet, and between companies A1-A3 and the savings is substantial to warrant setting up a separate management entity, but if it violates an IRS ruling, we don't want to do it.

Thank you!

Yeah, see, those additional facts change the situation a lot in this case. That looks almost exactly like a PEO arrangement. I think you can do it, depending on how Company B sets its transfer prices.

If you use either a zero profit charge/only actual overhead for the transfer price, I think you lose the argument that the transfer price is a reasonable price for an arm's length transaction, and that's a problem under IRC 267/267A and IRC 482. But if you set the transfer price with a reasonable allocated change for overhead and profit, I think you have a strong argument that Company B is engaging in something equivalent to an arm's length transaction, since Company B would be taking pricing risk and making profit for providing a service.

So given the additional information you provided, you can do it, if you set prices correctly.

 

[NYC Numbers]

Thank you!!