One of the ways to expand your small business that reaps huge benefits, while minimizing risks, is by adding a subsidiary. A parent–subsidiary structure provides liability protection, tax benefits, and facilitates future business plans. It could be the best next step for you.
What is a subsidiary?
A subsidiary is a legally separated business that is fully owned, and controlled by another company, usually referred to as the “parent” company. The parent company is the sole shareholder, or owner, of the subsidiary company.
Why establish a subsidiary?
Legal protection and tax benefits are two good reasons to create a subsidiary. Other reasons, more fully developed below, include using a subsidiary to penetrate a market or launch a product line. Sometimes it is a smart vehicle for focused development on one specific, segregated aspect of the business, but not all of it.
There may also be future plans of selling a portion of the business, or distributing different segments of the company among family members. Or, the company may have a higher risk of being sued, due to the nature of the business, and operating part of the business via a subsidiary can minimize that risk. All of these instances may justify the creation of a subsidiary. There are costs involved in the creation of a subsidiary, so it is typically best to do so only when those costs are minimal as compared with the resulting tax relief and other benefits.
How does a subsidiary operate?
A subsidiary operates independently while being under the control of the parent company. As a separate entity, the subsidiary has its own board of directors and officers that manage the day-to-day operations. But, the parent company has the power to modify the board at any given time, due to the fact that it’s the only stockholder, which effectively gives it control.
By being a separate entity from its parent, a subsidiary can be taxed, regulated, and held liable individually. That’s what makes subsidiaries such an interesting option for growing companies. The subsidiary is accountable to its parent company. The parent company has the legal right to have access to the subsidiary’s business plans and financial data, in order to regulate its progress, and protect the interests of the subsidiary and the parent company.
Advantages of creating a subsidiary
One of the main advantages of creating a subsidiary is the possibility to test new markets or new product lines without jeopardizing the assets and credit record of the parent company.
In the same line of thought, if that new product line or market isn’t as profitable as expected, having a subsidiary facilitates the selling of that portion of the company. And, if it is necessary for the subsidiary to seek creditor relief under the bankruptcy laws, its creditors wouldn’t be able to go after the parent company’s assets.
Now, let’s consider the opposite (and more positive) scenario, in which the subsidiary actually becomes profitable for the parent company. The parent then starts to receive dividends from the subsidiary, which can be used to fund the parent company and facilitate parent company growth.
Another advantage of the parent-subsidiary structure is the possibility of having local management teams instead of a centralized management structure. This allows the parent to have better control over the subsidiary day-to-day operations such as hiring personnel, credit options, and marketing decisions, and facilitates the implementation of corporate-wide procedures and strategies.
And finally, the main reason companies consider creating a subsidiary is the tax benefits derived from its structure. When filing federal income tax returns, the parent company can file a consolidated tax return, and include profits and losses from the parent company, as well as its subsidiaries. That way, total profits of the parent can be offset by the total losses, and the company pays less in federal income taxes. Also, some states allow subsidiaries to file tax returns only on the profits generated within that specific state, and not those generated in other locations. The same may be applicable for the profits of international subsidiaries, which will not pay income taxes in the U.S. but might do so at a significantly lower rate in the country where they’re located. In case of international subsidiaries, however, caution is warranted because regulations regarding taxation of parent-subsidiary foreign income can change rapidly.
Steps to creating a subsidiary
You will, of course, want to be guided by an experienced CPA, attorney, and business advisor, but once the decision is made, creating a subsidiary is not complicated. Basically, the steps are:
- Decide on where to set up your subsidiary.
- Create the new company. Follow the state or country’s laws to create the subsidiary. It can typically be a limited liability company or a corporation structure.
- Allocate assets and liabilities. As in any other business, all the necessary pieces must be put in place, before starting operations: capital contribution, inventory, machinery, accounts payable, accounts receivable, and so on.
- Create the subsidiary’s bylaws. Include that any changes to the bylaws are prohibited without permission of the parent company, as the sole owner; and that only the parent company can create or make any changes to the subsidiary’s board.
- Create the board of directors. The board should be very clear that the subsidiary is operated as an independent company, under the parent’s control.
— Having a subsidiary can bring many benefits to the parent company. It’s the best way to test the waters on new lines of business, new locations, and generate revenue while preventing possible legal liabilities, and financial damage. If you’ve been incubating several new ideas but aren’t sure of their marketability, maybe it’s time to consider dipping your toe in the water by launching a subsidiary.