What it is
TL;DRMulti-entity income shifting moves dollars from a high-tax entity to a low-tax entity through legitimate, arm's-length intercompany transactions, rent, royalties, management fees, employee leasing, so each dollar ends up taxed at the lowest defensible rate.
This is not a tax dodge. The IRS expressly permits intercompany transactions; what it does not permit is intercompany transactions with no economic substance or no arm's-length pricing.
The classic structures: a management company that bills the operating company for executive services; an IP holding company that licenses trademarks back; a rental LLC; and a captive insurance company (when revenue justifies it).
Who it's for
Businesses with $3M+ in pre-comp earnings and multiple legitimate functions (operations, management, IP, real estate) that can be cleanly separated.
- ✓Service or manufacturing business with material brand or process IP
- ✓Owner-managed operating company throwing off significant retained earnings
- ✓Multi-state operations where one state has materially lower entity tax
- ×Businesses without genuinely separable functions (don't manufacture entities just to bill yourself)
- ×Single-state, single-line operations under $1M EBITDA
- ×Owners who won't keep arm's-length documentation
How it works
1. Map the actual functions
List every function the business performs: operations, sales, executive management, IP development, brand stewardship, real estate ownership, equipment ownership.
Group them. Anything that is genuinely a distinct economic activity is a candidate for its own entity.
2. Price every intercompany transaction at arm's length
The IRS uses three primary methods under §482: comparable uncontrolled price, cost plus, and comparable profits. Pick the one the underlying transaction supports, and document why.
For management fees, a documented cost-plus method (cost to deliver the service + 10-25%) survives audit. Pulled-from-thin-air round numbers do not.
3. Move the function, not just the contract
If the management company bills $400,000 a year, the management company must actually perform $400,000 of work. Employees with payroll, dedicated email, signed deliverables, and time records, not just an invoice.
Form alone never controls. The IRS, courts, and state tax authorities look through paper structures whose substance does not match. Every intercompany dollar must be backed by something real.
4. Re-run the engagement annually
Fees and allocations that made sense in year one rarely still make sense in year five. Re-document at least every other year, and any time the business materially changes.
A worked example
Hannah owns an architectural services S-corp doing $4.8M revenue. The firm pays state income tax in five states under economic nexus rules. She creates an IP LLC in Wyoming that owns the firm's trademarks, project methodology, and CAD libraries, then licenses them back at 4% of revenue.
| Operating entity only | With Wyoming IP LLC | |
|---|---|---|
| State income tax exposure (all states) | $118,000 | $78,000 |
| Royalty deduction at operating co. | $0 | $192,000 |
| Federal tax on royalty at IP LLC | , | $71,000 |
| Federal tax saved at op co. | , | $71,000 |
| Net annual saving | ≈ $40,000 (state tax) |
The federal tax is a wash (income just moved), but the state tax saving is real, recurring, and roughly $40,000/yr, provided the royalty is supported by an outside valuation and a real license agreement.
Limits and risks
Several states (notably California, New York, and Texas) have anti-PIC (passive investment company) rules that disallow royalty deductions paid to related out-of-state IP holders. The strategy only works if the operating state actually allows the deduction.
If the IRS finds the structure has no substance, no employees, no actual IP development, no genuine business purpose beyond tax, it can collapse the entire arrangement under the sham-transaction doctrine.
The two questions every examiner asks: was the price arm's length, and did the entity actually do anything? An outside transfer-pricing study (or even a defensible internal one) plus real operational records answer both.
IRS reference
- IRC §482IRS authority to reallocate income between related entities to clearly reflect income.
- IRC §269APersonal service corporations principally performing services for another related entity.
- Treas. Reg. §1.482-9Methods for evaluating intercompany service transactions.