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Diane Kennedy, CPA, joins Anthony Verna for episode 33 of the Law & Business podcast.
Diane has written a dozen or so books and had the fortune of hitting the New York Times, Wall Street Journal and Business West best seller lists with some of them. That’s even more remarkable because her books are about tax, accounting and investing. They aren’t your typical beach books.
Diane and Anthony talk about the need for corporate structuring and the possibility for licensing within holding and parent-child companies for intellectual property use.
Diane does recommend having holding companies that own IP and fully discusses the asset protection that is in place for the business. Ownership and licensing matter greatly to the tax ramification.
Here is a lightly-edited transcript of the podcast episode:
Anthony Verna:
Hey everyone, welcome to the Law and Business podcast. We’re conferencing with Diane Kennedy, CPA as everybody knows her, right?
Diane Kennedy:
Well, I don’t know about that, but your listeners will soon meet me.
Anthony Verna:
Yeah, but nobody just calls you Diane. It’s always Diane Kennedy, CPA.
Diane Kennedy:
Yeah, typically. Yeah, I make my kids call me that too. So, just so you know. I’m kidding.
Anthony Verna:
As you should, that power trip, wherever your kids is always important. Yes. Says the guy who doesn’t have any. So, Diane, why don’t you tell everyone a little bit about your practice. I know you can be found over at ustaxaid.com but a little more than a plug. Why don’t you tell everybody about yourself?
Diane Kennedy:
So I’ve been a CPA for a lot of years and I have a practice that focuses exclusively with small business owners and their businesses, obviously, and or real estate investors. So, with that focus, then we’re able to really just hone in on how do we help you with strategies that build up the value of your business, create cashflow, and most importantly, how do you legally save on taxes? And I also write a lot of books. My latest is Tax Again 2018: How to Brace for the Trump Tax Plan. And the, the whole viewpoint of books I write is it’s not an argument about whether tax law is right or fair or overthrow this or whatever. It’s just simply how do you make use of the things that are in law right now? The rich have lots of advisors and they pay a lot of money for those.
The average guy who’s got a business and is working hard or trying to build up some real estate investments, they can’t afford the team of experts that the rich have. And yet those same exact legal tax loopholes exist for everyone as a business owner or a real estate investor. So, it’s just simply taking that arcane language and changing it so it’s more accessible to everybody. That’s the idea. By the way, I just turned down a client who had $1.1 billion in assets. So that’s it. And I should say net worth of 1.1 billion simply because he didn’t fit the model. And it’s like, you know, you can hire a lot of really expensive people. You don’t need me, but I want to work with the guys who can’t get the experts or can’t afford them normally. So, these are ways that we can provide you those services most efficiently.
Anthony Verna:
Wonderful. So today, let’s talk a little bit in my wheelhouse. Let’s talk a little intellectual property. And one of the discussions I like to have with my clients is I say you need to sit down with your business’ CPAs and you need to talk about what is right for your intellectual property. Meaning, is it right for your company to spin off a parent or spin off a child, some kind of sibling company? And what does that mean for your taxes? And the usual setup is that intellectual property sits in a holding company and in the regular company there’s a licensing agreement so that a payment is made from the original company to the holding company for a license. And then this way there’s a payment made and there are tax ramifications. None of which I ever handled in my practice. So, Diane, why don’t you take it away from my bumbling words as to what I’m trying to say?
Diane Kennedy:
Right. Well, you know, actually, a lot of things changed effective January 1st, 2018 with the new tax plan that is the Tax Cuts and Jobs Act, also known as the Trump tax plan and quite likely a lot of business owners.
Anthony Verna:
Which you also call Taxmageddon.
Diane Kennedy:
Well, you know, and that all by the way, it came with the idea that there were so many thinking, this is the end, it’s not going to work. It’s like, no, it’s just a change. And that’s what the entire book is about. It’s not really taxmageddon. Again, it’s just a change. But if you think it’s not a big deal, you’re going to have a huge awakening this next year when you find out that you thought you were getting a refund and you’re suddenly paying a lot of money or you thought you were breaking even and you’re paying a lot of money because you just did that survey, two out of ten Americans are going to have to pay this next year and they aren’t expecting it.
So anyway, but that all said you might have different entities you choose now, but in general that same concept is very accurate. I like to have the IP separate from the operating company. There’s a number of reasons for that. One is for asset protection. In essence with IP, you’ve created something of value out of nothing. I mean it, it has very little basis. It’s just your ideas and your systems and I don’t mean to say that’s nothing, but, normally if I want to have a commercial office building, I have to put some money into it. This is an asset that is from your ideas and your hard work. Protect those, keep them separate from your business. Additionally, I run into clients that after they find a system that works really well for them and they’ve got this IP sitting there, then they start thinking, well, it’s not just licensing it to myself, but I might want to license it to others so it becomes other income streams there.
I mean, maybe someday you franchise or maybe it’s just you let people use your ideas, take your idea and spin it into other businesses, other bricks and mortar or take it online and maybe you have a different partner or whatever, there are different businesses and business structures. But the idea is that IP is still held in there and they’re still licensing agreements and there’s an income flow and that’s yours. As far as what kind of entity that’s generally the question that most people are asking me is, what do I hold my IP in? I prefer to hold it in something that’s like an LLC, a limited liability company. The reason for that is that it allows for flow through taxation. So. income or expenses that are made their flow through to your to your personal tax return, which may or may not be a benefit.
But the biggest thing is that if this IP could get big at some point, somebody may want to buy it from you. And if that happens, you created an appreciated asset. And anytime we have an appreciating assets, we don’t want to hold those inside a corporation. All kinds of bad things happen. You’ve got more tax you pay, and then you’ve got this issue of how do I get the money out of the corporation? So, then you have to take dividends. And that’s where we get the whole idea of double taxation and C corporations. So, I prefer just to have the IP sitting in another LLC and having it separate and then make sure you’ve got good agreements back and forth. You know, I’m speaking to a lawyer and talking about asset protection, but the fact is if anybody ever challenges you, you need to make sure you’ve got good paper trails and you treated that like a separate entity.
Anthony Verna:
I think another thought here that comes to mind is not just the licensing agreement but also the value. How do you look at the value of intellectual property, say at conception, so that if you’re going to set this up, your license and your agreement and the royalty amount being paid from one entity to the holding company is, you know, the operating company to the holding company is not illegitimate, for lack of a better word?
Diane Kennedy:
Right. And it’s, boy, that’s such a tough one because accountants, we’re always looking, what’s the basis, what do we have into this? So again, using that example of a commercial office building, okay. It’s like, you know, it’s a million-dollar building. I put $200,000 into it. I mean, I know what it is. I’m looking at what my ROI should be. You know, you have all those kinds of facts.
Anthony Verna:
And something like that. You get like you look at what’s been built into it. When houses are renovated, and every single nail is deductible, and you don’t necessarily have that. You may have attorney’s fees for getting your trademark and that’s about it.
Diane Kennedy:
Yeah, exactly. So, what is the value? Well, on the books it’s close to nothing. I mean seriously what you’ve got is your attorney’s fees most likely and maybe you know some work around that, just getting the that stuff trademarked or patent or whatever it is that that IP is and that’s all. Now what is the value of it? In that case we’ve got to look at what the cash flows are going to be and so it almost becomes kind of a circular argument like, well we’ve got to determine what the value is and just determine how much the royalty payments should be. And it’s like, no, I think it’s more important that we look at the royalty payments that are for the industry. For example, I might look at something like Subway, if you’re starting a submarine sandwich shop or a sandwich shop, and what is the licensing agreement?
If you get a Subway franchise, what do you have to pay for the use of their systems and there is an amount you’re going to pay for that on a monthly basis. You know there’s probably a marketing amount. That then becomes, okay, if that’s the number we’re going to start using, then what is the value of that future cashflow and from that, that’s where you start to kind of do evaluation. I think that’s a really important question though, not just for how do we make sure our documents now are right, but let’s say for your estate 10 years down the line and you’re looking at, okay, I need to leave this to my heirs. What is the value of this thing going to be? If you don’t establish the way you want it valued, the IRS is going to do it for you when you die and trust me, they’re going to value it as high as they possibly can because they’re trying to going to try to collect some estate tax if you’re close to that number.
So, I don’t have a great answer other than to tell you it’s really important. I think what I would do is look at what is a reasonable royalty payment. And like you said, it’s based on net profits or gross profits or there’s something in the industry for something similar. And then based on that, that’s going to tell us what our income stream’s going to be and then just do a calculation of present value of the future cashflow. And now we’re just talking math. I’m not going to spew that off the top of my head. But there’s formulas that give you that information. And then based on that, you’d have maybe valuation that you reassess every year.
Anthony Verna:
And I think this valuation is an important point. Diane, got an episode coming up where Will Jacques, my patent agent, and I talked about damages in an infringement lawsuit.
And the first question there is, how much is your IP worth? What I find important here is that if your valuation is way off here at the beginning it’s probably going to be way off down the road.
Diane Kennedy:
Right. And I think at the very beginning it’s hard to value it because we don’t know what the market’s going to be. And that’s where I like, and again, speaking as a CPA solely as a CPA, I like the idea that part of your annual minutes, even though you’re not required to have annual meetings in an LLC, I would do that at least annually and record that information. And as part of that, the LLC manager or members, however it’s set up, signs off on the fact that this is the valuation formula we’re using. And based on that, this is what we say the value of it is now. You get sued in the first two months
it’s difficult, but a couple of years down the line, you now have a track record of this is how we do our valuation.
Anthony Verna:
But that happens too. Either being sued in the first two months or the need to file a lawsuit in the first two months. I mean, even this week I’ve spoken to somebody who the business is new, and they already see trademark infringers out there.
Diane Kennedy:
Wow. You know? Wow. I guess maybe what it is, it’s like, this is where we do this kind of pulled from the air PFA and I just like to be determined later. But meanwhile we’re going to say this is what the value is.
Anthony Verna:
But when you said PFA, I thought you meant something else.
Diane Kennedy:
I know you did. I feel like we were taping up. The general thought though is, I mean, in accounting, sometimes people start LLCs or corporations or anything and they don’t put any value for their stock or their units on the books. They just start off with, well, you know, we just gonna start it and we’ll just get going. And then they get into trouble because if you then got a problem with, is this really a legitimate entity because almost every entity needs something to get it going. Put a thousand bucks in there, do something so that there’s an amount shown to start with the beginning capital amount and that then shows for the books and records and the tax return you file that there is value in that from the very beginning.
Anthony Verna:
I think it’s a very important point that you add something per valuation and that’s something that I speak until I’m blue in the face about, and I know that a lot of small businesses out there are just happy to get their copyright trademark or patent certificate and I don’t want to say be done with it, but then their business moves on without much of a thought on what the value is behind the certificate.
Diane Kennedy:
Yeah, totally understand. I run into that. I see the guys who just started a business and they’re so busy working and fulfilling and figuring out systems and employees and inventory or you know, whatever it is they’re doing, that they don’t have time for the little nuances. And then sadly, 10 years later, if there’s a problem, that’s the thing that could have taken them a couple of hours, ends up costing them hundreds of thousands of dollars. So, part of it is to say it, you know, you’re going to have to, it’s going to be one more thing on your to do list.
Anthony Verna:
All right, so some of the thoughts here on transferring IP to a holding company. You said make it in an LLC. And you specifically said don’t make it a C Corp, right?
Diane Kennedy:
Yeah. I don’t like to put appreciating property or property that has a chance of going up in value to appreciate them. Not as opposed to depreciate, but appreciating in value for tax consequences. It’s hard In a C Corp. Now, there are a lot of other reasons to have a C Corp you’re going to go public or something. So maybe that’s not a choice. Maybe you have to have a C corporation, in which case that’s what it is.
Anthony Verna:
Sure. And then start creating the value and valuation right away by putting money into this whole incorporation,
figuring out what the future value is worth and starting those royalty payments from the operating company to the holding company.
Diane Kennedy:
Absolutely. Yeah. And it’s not even just the valuation, it’s the valuation formula, because the valuation is going to be dynamic. It’s going to be changing.
Anthony Verna:
Understood. Completely. All right then, Diane. I know this is a bit of a mini-sode, but thank you for coming on and we’re going to have you on again very soon, aren’t we?
Diane Kennedy:
Thank you. I enjoyed it.
Outro:
This has been the Law and Business podcast. Visit Vernalaw.com for more episodes. To contact Verna Law PC, send an email to Anthony@vernalaw.com or call (914) 358-6401.