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Layering a holding company in October 2020: the stack after the 199A dust settled

The DRD tiers are unchanged, the final 199A regs finally landed, and opportunity-zone holdcos changed the shape of the chart

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 8 sections
  1. The DRD tiers, still 50/65/100
  2. The 199A final regs: the parts that matter for stacks
  3. The LLC-over-LLC stack with 199A, cleanly
  4. Where opportunity-zone funds sit
  5. Mixed stacks and the same old trap
  6. Check-the-box remains the hinge
  7. Rule of thumb
  8. Sources

holding company that owns an operating company can still be taxed twice on the same dollar, and the rules that prevent it have not changed in thirty months. What has changed is the guidance around them. The 199A final regulations in T.D. 9847 (February 2019) and the follow-up in T.D. 9889 (December 2019) have settled most of the open questions for pass-through stacks, the dividends-received deduction tiers under IRC § 243 are still 50, 65, and 100, and opportunity-zone funds have become a third shape on the chart.

This piece is the October 2020 update to the April 2018 layering piece, which walked the math when the TCJA ink was still wet. The math has held. The qualifications around it are now written down. If you read the 2018 version, read this one for the 199A aggregation mechanics, the T.D. 9889 RPE reporting rules, and where a QOF sits in a stack that was otherwise built for DRD.

The DRD tiers, still 50/65/100

IRC § 243, as amended by the Tax Cuts and Jobs Act in December 2017, has not been touched since. A C-corp that receives a dividend from another C-corp deducts a percentage of that dividend, and the percentage is a function of ownership. Under § 243(a)(1), the baseline deduction is 50% when the recipient owns less than 20% of the payor. Under § 243(c), as amended, the deduction rises to 65% when the recipient owns at least 20% but less than 80%. Under § 243(a)(3) and (b)(1), tied to the affiliated-group definition at § 1504(a)(2), the deduction is 100% when the dividend is a "qualifying dividend" inside an 80%-vote-and-value affiliated group.

Those three numbers are the spine of any C-corp-over-C-corp stack. Combined with the 21% corporate rate under IRC § 11(b), the residual tax on an intercorporate dividend is roughly 10.5% at the 50% tier, 7.35% at the 65% tier, and zero at the 100% tier. The architecture continues to reward concentration: get to 80% and the upward dollar is clean, stay below 80% and every dividend is clipped.

One thing that has become clearer since 2018 is how the IRS reads the § 1504(a)(2) "vote and value" test in practice. The statute requires both 80% of total voting power and 80% of total value of stock (other than § 1504(a)(4) preferred). If a sub has a second class of common held outside the group, even a small slice, the value test can fail even when the vote test passes. Deal lawyers have been papering recapitalizations before consolidation elections more carefully this year for exactly that reason. The statute is unchanged; the attention to its second prong is what shifted.

The 199A final regs: the parts that matter for stacks

IRC § 199A, added by TCJA § 11011, gives non-corporate taxpayers a deduction of up to 20% of qualified business income from pass-through entities, subject to a W-2 wage and UBIA limitation above threshold income (§ 199A(b)(2)), and to a full phase-out for specified service trades or businesses above the ceilings in § 199A(d)(3). In April 2018 the statute existed, the proposed regs did not, and the most common practitioner answer to "how does this work in a holding-company stack" was "we are waiting for guidance."

The guidance arrived. T.D. 9847 (published in the Federal Register February 8, 2019) finalized the bulk of the § 199A regulations, including Treas. Reg. §§ 1.199A-1 through 1.199A-6. T.D. 9889 (December 27, 2019) followed up with final rules on previously suspended losses, qualified REIT dividends from RICs, and the treatment of the § 199A deduction by a trust or estate. Between the two, the open questions from 2018 are largely closed.

Three pieces of that final regulatory package are load-bearing for anyone layering flow-through entities.

Aggregation under Treas. Reg. § 1.199A-4. Owners of multiple pass-through trades or businesses can elect to aggregate them for purposes of the W-2 wage and UBIA limitation, but only if five tests are met (Treas. Reg. § 1.199A-4(b)(1)): the same person or group owns 50% or more of each trade or business for the majority of the year and at year-end, the aggregated businesses report on the same tax year, none is a specified service trade or business, and at least two of three connection factors are satisfied (common products or services, shared facilities or centralized business elements, or operation in coordination with or reliance on one or more of the businesses in the aggregated group). Aggregation is elected on the individual return, not the entity return, and once elected, must be maintained in subsequent years unless facts change materially.

For a holding-company owner with several operating LLCs below, the aggregation election can be the difference between getting the full 20% deduction and getting capped by a sub that happens to be asset-heavy but wage-light, or wage-heavy but asset-light. Document the five tests at year-end. Disclosure is required on Form 8995-A, Schedule B under Treas. Reg. § 1.199A-4(c)(2), and failure to disclose can forfeit aggregation in the year at issue.

RPE reporting under Treas. Reg. § 1.199A-6. Relevant pass-through entities (partnerships and S-corps that allocate QBI, W-2 wages, and UBIA to their owners) must report those items on a statement attached to each K-1. If an RPE fails to report, Treas. Reg. § 1.199A-6(b)(3) presumes zero QBI, zero W-2 wages, and zero UBIA for that owner's share. A two-tier LLC-over-LLC stack has to push the detail up through each tier. Miss a schedule, and the ultimate owner takes a zero. This is a compliance burden the 2018 piece could only gesture at; it is now a hard rule.

SSTB look-through. Treas. Reg. § 1.199A-5(c)(2) cracks down on the planning trick of spinning administrative functions out of an SSTB into a separate wage-paying entity and renting them back. If 50% or more of a trade or business's gross receipts come from providing property or services to an SSTB under common control (50% or more common ownership), the providing trade or business is itself treated as an SSTB to the extent of the cross-receipts. In a holdco stack where a professional services sub and a back-office sub share ownership, the back-office is not a clean way to create QBI.

The LLC-over-LLC stack with 199A, cleanly

Consider an individual who owns an upper-tier LLC that is a partnership for federal tax purposes, which in turn owns three wholly owned lower-tier LLCs that are disregarded. Each lower tier is a single-member LLC of the partnership; under Treas. Reg. § 301.7701-3, each is disregarded back to the partnership. The partnership files Form 1065, issues K-1s to the individual, and the individual computes § 199A on her return.

If the three operating businesses are functionally related (one sells retail, one wholesales to the same retail customers, one warehouses inventory for both), the owner can elect aggregation under § 1.199A-4 and test the W-2 wages and UBIA on the combined pool. If they are unrelated (retail, real estate rental, consulting) the owner cannot aggregate and each is tested separately. The rental activity has to clear the trade-or-business bar, which for most real estate holdings runs through the Rev. Proc. 2019-38 safe harbor (250 hours of rental services per year, separate books, contemporaneous records) if the owner wants a clean QBI answer.

The stack produces no dividend at any layer. No DRD question arises. The § 199A deduction is computed once, at the top, on the owner's individual return. State-law liability separation between the three operating LLCs is preserved. Federal tax compliance is one partnership return plus one Form 1040 with a Schedule E and a Form 8995-A.

Where opportunity-zone funds sit

Qualified opportunity funds (QOFs) did not exist in a usable form in April 2018. The statute was enacted by TCJA § 13823 (IRC § 1400Z-1 and § 1400Z-2), but the initial regs (T.D. 9889, December 2019) were not final until late last year. By October 2020 the shape of a QOF inside a holdco stack is legible.

A QOF is a corporation or partnership organized for the purpose of investing in qualified opportunity zone property, holding at least 90% of its assets in QOZ property measured semi-annually (IRC § 1400Z-2(d)(1)). An investor who rolls eligible capital gain into a QOF within 180 days defers recognition until the earlier of sale of the QOF interest or December 31, 2026, gets a 10% basis step-up at 5 years of holding (15% at 7 years, but the 7-year step-up is effectively unreachable for deferrals made after 2019 given the 2026 recognition date), and pays zero federal tax on appreciation of the QOF interest itself if the interest is held for 10 years under IRC § 1400Z-2(c).

The structural oddity is that a QOF must itself be a partnership or corporation. It cannot be a disregarded entity. So the cleanest way to bolt opportunity-zone investing onto an existing LLC-over-LLC stack is to form a separate QOF partnership (or C-corp) that the owner funds directly with eligible gain, not through the holding LLC. Dropping a QOF into the middle of an existing stack usually fails at least one of the investment-testing rules, because the QOF acquires its OZ property from a related party (the existing sub), which is disqualified under IRC § 1400Z-2(e)(2) and Treas. Reg. § 1.1400Z2(d)-1(a)(3).

A practical October 2020 build: leave the operating stack alone, form a separate QOF partnership for capital-gain deferral, hold it alongside the holdco in the owner's name or in a trust, and let the two structures not cross. QOFs are an allocation bucket, not a holding-company component.

Mixed stacks and the same old trap

The error that dominated stack architecture in 2018 still dominates in 2020: an LLC (pass-through) parent that owns a C-corp sub. The sub pays 21% on its profits. When it distributes to the LLC parent, the distribution is a dividend. The parent is not a corporation, so § 243 is unavailable; DRD is a corporate-shareholder benefit only. The dividend passes through the partnership, is taxed at the qualified dividend rate if the 60-of-121-day holding period under IRC § 1(h)(11) and § 246(c) is met, and picks up the 3.8% net investment income tax under § 1411 for owners above the threshold. Effective total burden on the distributed dollar: 21% corporate plus 23.8% shareholder, or roughly 39.8%. Two layers, full double tax.

The 2020 version of the trap adds a wrinkle: putting operating activity in a C-corp parent to "get the 21% rate" and hold pass-through subs below it still loses § 199A entirely, because § 199A(a) is available only to non-corporate taxpayers. A C-corp parent eats its subs' QBI as ordinary Form 1120 income at 21% and the individual owner gets nothing. The math pencils only when the business plan is retention (reinvesting at the corporate level for years without distribution), not distribution. Most closely held businesses distribute. Most closely held businesses belong in pass-through wrappers.

Check-the-box remains the hinge

Treas. Reg. § 301.7701-3 has not been amended and remains the most useful planning tool in the stack designer's kit. Form an LLC parent and LLC subs, elect C-corp treatment only where it is genuinely needed (a sub that will hold qualified small business stock under IRC § 1202, a sub that will raise institutional capital, a sub that sits inside an affiliated group for consolidation purposes), and leave everything else disregarded or partnership. The 2017 holding-company structures piece walked the basic shapes; what has changed since is only that the penalty for a wrong guess has become more expensive, because § 199A now rewards getting the flow-through side right.

The one-way ratchet still applies. An LLC can elect to be a corporation via Form 8832 at any time. A corporation cannot elect to be a disregarded entity without liquidating, and liquidation is taxable under IRC § 331. Design the stack for the direction you might want to move in, not the one you are stuck in.

Rule of thumb

If every wrapper is a pass-through, double tax is structurally impossible and the only 2020 question is whether the owner qualifies for § 199A aggregation under Treas. Reg. § 1.199A-4; if any wrapper is a C-corp, the parent above it must own 80% of its vote and value (for 100% DRD or consolidation) or every upward dollar is taxed twice.

Sources

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