Do I Need a Subsidiary to Transact My Business?

Provided by:  Jennifer Kirschenbaum, Esq.

June 9, 2021

Question: 

Dear Jennifer,

I am starting a business and a friend of mine suggested that I set up a subsidiary to conduct the business through an operating entity.  Do I need a subsidiary to transact my business?
 
- T.J.
 
Answer: 

Written by Jodi Perlman, Esq.: Jperlman@kirschenbaumesq.com

Hi T.J.,
 
By way of background, a parent holding company (“Holdco”) is an entity that is set up for the purpose of owning a majority or more of the interests in other entities.  The companies in which the Holdco owns shares or units are called subsidiaries (“Subs”).  The Holdco usually does not produce goods or perform services itself, nor does it transact day-to-day business.  However, it often owns the assets that are used by the Subs which it owns.  There are definitely pros and cons to setting up a corporate structure with a parent holding company owning a subsidiary operating company and I will run through some of those below.
 
First, let’s address the pros. 
 

• Limitation of Liability and Asset Protection. In most circumstances, the Holdco would not be liable for the actions of the Subs, which is one of the primary reasons for companies to form operating entities through Subs.  If the Holdco owns the valuable assets of the enterprise, such as real property, equipment or other personal property, and/or intellectual property, those assets would not be subject to claims of business creditors of the Subs.  As long as both companies act in good faith, and respect corporate formalities between the companies, then the Holdco would be shielded against the liabilities incurred by its Subs and its assets protected.  Each Sub is a separate legal entity and can sue and be sued independently of the Holdco.

• Taxes. Tax benefits are also a significant reason to structure a company through a Holdco and Subs.  A Holdco might be able to offset profits generated by one Sub with losses incurred by another Sub.  For specific tax benefits, please consult your tax and accounting advisors and refer to applicable state and federal laws. Note that an S corporation cannot be a Sub, because, by law, an S corporation can only be owned by individuals and not by other businesses.

• Independent Management. A Sub can have a management structure independent of the Holdco which can allow certain management activities at the Sub level, with or without Holdco approvals and controls.  A separate management structure for the Sub with designated officers and managers performing the day-to-day activities of the Sub would also enable compensation of certain officers and managers to be based upon the performance and operational goals of the Sub.

• Additional Ownership Interests. Since a Holdco is only required to own 51% of a Sub, the Sub can include additional investors or key persons with ownership interests in the Sub, without diluting or affecting the ownership interests of the investors in the Holdco.

• Decision-Making Control.  Because the Holdco would own at least 51% and as much as 100% of the ownership interests in the Sub, the Holdco can configure and exercise control over the decisions of the Sub, whether through a Board of Managers or other voting controls.

• Resource Sharing. If the Holdco owns assets and receives cash flow from the Subs, the Holdco might have the means of providing resources on behalf of the Sub, such as efficiencies in purchasing power, marketing and tech support, research and development funds, staffing and benefits, and other resources and support that the Subs could not afford or arrange for independently.

• Separation of Businesses.  A Holdco could use Subs to separate different aspects of the business without affecting its principal operations. Further, by splitting different business components operationally into Subs, the Holdco and Subs could achieve greater operational efficiencies by having smaller independent companies, which would also be helpful should the Holdco wish to spin off a portion of its overall business. 

 
Second, let’s address the cons.
 

• Taxes. Please consult your tax and accounting advisors to avoid the possibility of multiple taxation concerns.

• Decision-Making. If the Holdco retains control over major management decisions for the Subs, whether involving budget, financing, or other operational issues, then such matters may require compliance with certain corporate procedures and bureaucratic controls in order for such actions to be taken by the Sub. If the Holdco retains less controls, it could be compromised in controlling operations and revenues of the Sub.

• Parent Liability for Certain Acts. There are occasions in which a Holdco can be held liable for the actions of the Subs. If the companies fail to respect corporate formalities between the companies, and could be deemed as one legal entity, then the Holdco might be held accountable for the liabilities incurred by its Subs. Further, a third party lender may require the Holdco to guaranty the debt of the Sub, thereby putting the assets of the Holdco at risk. 

• Legal and Tax Costs. Because the corporate structure of having a Holdco and one or more Subs is more complicated than having a single operating entity, legal, tax, accounting and filing costs will be more significant for organization and maintenance of this structure. 

 
Finally, any proposed corporate structure, or changes to an existing structure, should be discussed at length, and reviewed, with your accountant so you have a clear understanding as to the flow of income between entities and to the owners, and how each entity and its respective shareholders or members will be taxed.