Introduction:
A subsidiary is simply a corporation or other limited liability entity controlled and majority owned by another limited liability entity. The entity so owned is usually a corporation but it could be any limited liability entity majority owned by another entity. Most large publicly traded corporations have many subsidiaries, often dozens or even hundreds. The author remembers well when his high executive witness for a large Japanese multinational, was asked in deposition how many subsidiaries were owned by the parent company. He paused, then stated he simply did not know. “Over a hundred,” he guessed. In reality, it was over three hundred subsidiaries scattered around the world.
But subsidiaries can be useful for nonpublic privately owned entities as well. This article shall discuss the basic pros and cons of subsidiaries.
The Basics:
A corporation is a mini republic, with stockholders voting for directors who strategically operate the company and who, in turn, hire officers who run the day to day operations of the company. Shareholders normally vote in the board of directors annually and officers normally serve at the pleasure of the board.
In California, a majority shareholder (51% or more) essentially controls the company. While minority owners can elect a certain number of the directors based on their percentage of ownership, the majority shareholder can almost always elect a majority of the board of directors. That, in turn, means that the majority shareholder indirectly appoints the officers via the board of directors. While written agreements among the shareholders can alter that dynamic, most companies operate without any such agreements.
A corporation or other limited liability entity can own another limited liability entity. Essentially, a subsidiary is a corporation in which a majority (or all) of the shares are owned by another limited liability entity, usually another corporation. It can also be a limited liability company in which a majority of the interests are owned by another limited liability entity.
There is no legal limit on the number of subsidiaries a corporation can own and those subsidiaries can be limited liability entities formed or engaged in business in foreign jurisdictions. The subsidiary is set up just as any other corporation: the only difference is a majority of the stock…or all the stock…is issued to another corporation. If all the stock is owned by the other corporation, the subsidiary is called, “a wholly owned subsidiary.” The corporation owning a majority or more of the stock is called the “parent” corporation.
There is another variation of the structure in which two entities own each other…each owning an equal (or inequal) number of shares of the other. Those are usually referred to as “brother-sister” or “brother corporations.”
There are certain limits in ownership. Some states prohibit trusts from owning stock in a subsidiary. Subchapter S status for an entity in certain circumstances can be more difficult if subsidiaries are involved.
And, of course, there is a need for separate accounting books, tax returns, third party contracts and forms and meetings of directors and shareholders for each entity. That can get expensive since one needs the CPA to file two or more returns and often legal counsel to assist with the agreements and minutes.
So, why go to the added trouble and expense? Why not just have the already existing entity engage in the business without bothering with creating a subsidiary? There must be valid reasons or there would not be tens of thousands of subsidiaries existing in the world of business.
Why Create a Subsidiary?
There are various purposes, among which are:
- There is more limited liability protection. If a subsidiary has a claim against it, it will not necessarily result in a claim against the parent company assuming the parent company has not signed a guaranty and/or has not transferred funds back and forth incorrectly. Thus, the subsidiary can engage in higher risk business and the risk to the parent company is only the assets that it has invested in the subsidiary.
- There is ability to have different owners and operators for each entity. Assume I wish to open a company in a new locale and want to incentivize the manager but do not want the manager to own a part of my business even as a minority owner. I can give that manager ten or twenty percent of the subsidiary, keeping majority control with the parent company, and not have the manager own any of the parent.
- It can allow some diversification in tax planning and structural allocation of ownership.
- It can allow the parent company to own “local” companies while maintaining its own identity. Thus, X company incorporated in California can own a Delaware or Texas company and operate in that state as a local company.
- It can allow the parent company to have pension plans and benefits that are not necessarily available to the owners or employees of the subsidiary.
- It can allow sale or investment in one entity without having to invest in or sell the other entity.
There are some disadvantages:
- It costs money to create and monitor the separate entities and may increase total taxes due depending on the state in which a subsidiary is located.
- Minutes and documentation must be kept separately for each entity, including books and tax records, resulting in possible increase in professional fees.
- It increases the complexity of the overall business structure which may concern financial institutions who are financing the operations. (Though most financial institutions are quite comfortable with parent subsidiary relationships so long as sufficient assets exist in the subsidiary.)
- It may increase the chance for audits since taxing authorities may be concerned that expenses are improperly assumed by one or the other entity.
But the very fact that tens of thousands of subsidiaries exist makes it clear that the advantages often outweigh the disadvantages.
Brother Sister Companies:
A variation of connected companies is mutual ownership of two or more companies. Thus X company owns fifty percent of Y company which owns fifty percent of X company. (Percentages can vary and more than two companies can be involved.) These are often called brother sister companies, unlike parent subsidiary companies in which one company controls the other via ownership.
Brother Sister companies allow different ownership and benefits to the various owners of the separate entities but does not allow one to fully control the other.
The Major Danger of Subsidiaries:
Aside from the obvious disadvantages of increased cost and complexity, the major danger we have encountered is that the owners do not take the time to keep separate books, minutes, contracts, etc. and mix their operations so much that the ability for third parties to “pierce the corporate veil” and allocate liabilities across the board becomes possible. It is essential to treat the entities separately with separate books, tax returns, contracts, etc. or the courts will ignore the separation and call the existence of multiple entities a sham. This can result in the limited liability or separate tax status being nullified.
It is also essential to recall that the fiduciary duty one owns to an entity as a manager or director or officer requires one to perform to the best interests of the entity. It is vital to ensure that the interests of the entities do not conflict and to plan ahead to avoid that problem.
As an example: Assume I own a general construction company but have started a subsidiary that provides a particular material, such as lumber for building. The pricing charged by the subsidiary to the parent must be commercially reasonable or the officers may be violating their duty to the subsidiary.
This could result in some friction. Assume a major increase in the cost of lumber in the market. The subsidiary would wish to increase the pricing for the parent and the parent, which after all owns a majority of the interest in the subsidiary, may want the price to remain low. If the parent forces a low price on the subsidiary, the officers of the subsidiary may breach their duty to the subsidiary by so agreeing and the separation of the two entities may be challenged later by both taxing authorities and third party creditors since the subsidiary acted against its own self interest.
As one elderly businessman told his son who was operating the subsidiary in an e mail, “You are not me. Act in your own interest. That’s your obligation. Maybe I’ll make money in the long run if you do it right.”
Conclusion:
Subsidiaries are useful tools in business as recognized by many of the larger companies in the market. They require more care and more expense but can have various benefits in limiting liability and allowing more flexibility in ownership, operations and benefits. One should carefully examine the pros and cons before creating them but to ignore their benefits would be foolish, indeed.