| EXECUTIVE SUMMARY | 
CERTAIN DEVELOPMENTS IN A COMPANY’S LIFE CYCLE can trigger the need for a subsidiary, such as the launch of a new venture with different risk characteristics than the company’s existing line of business or the opening of operations in a new state or foreign country. Other times, companies need to form subsidiaries to facilitate the potential sale of part of the company.
FROM AN ACCOUNTING PERSPECTIVE, creating a subsidiary makes sense because it allows companies to enjoy substantial tax benefits and creditor protections. The costs involved can be as little as a few thousand dollars for smaller companies, and when costs are higher, they are almost always nominal compared with potential rewards.
THE PRINCIPAL TAX BENEFIT associated with adopting a subsidiary structure is the ability, on federal income tax returns, to offset profits in one part of the business with losses in another. Forming a subsidiary also can provide tax benefits at the state level.
WHILE CREATING A SUBSIDIARY will clearly help to achieve corporate aims, companies and their advisers must structure the deal so it does not run afoul of federal tax, employment and benefit regulations. Companies must be especially mindful of the rules governing qualified plans, such as pensions or profit-sharing vehicles subject to federal laws.
CPAs WHO ADVISE on when and how to create a subsidiary should have strong grounding in tax regulations, particularly those relating to intercompany transfers of assets or liabilities. | | RANDY MYERS is a freelance financial writer who lives in Dover, Pennsylvania. His e-mail address is randy@randymyers.net . | 
t happens every day: One company decides to buy another or it enters into a new line of business and comes face-to-face with the question of whether to structure the new venture as a separate legal entity—a subsidiary—or simply fold it into the company’s existing operations. For CPAs whose employers or clients may be growing beyond a single-entity structure, this article explains when it makes sense to take the subsidiary route.
Certain routine developments can trigger the need for a subsidiary. Often, says CPA and tax attorney Mike Farra at Miami-based CPA firm Morrison, Brown, Argiz & Co., it will be the launch of a new venture that has different risk characteristics than the company’s existing line of business or the opening of operations in a new state or foreign country. Other times, companies need to form subsidiaries to facilitate the potential sale of part of the company. From an accounting perspective, creating a subsidiary generally makes sense under any of these conditions because it allows companies to enjoy substantial tax benefits and creditor protections. There are costs involved—hiring attorneys to draft and file the necessary legal documents, for example, and paying CPAs to handle marginally more complex tax returns. But those costs may be measured in as little as thousands of dollars for smaller companies, and even when costs are higher, they almost always are nominal compared with potential rewards from legal protections and tax benefits.
| TAX RELIEF The principal tax benefit associated with adopting a subsidiary structure is the ability of a company, on federal income tax returns, to offset profits in one part of the business with losses in another. Suppose, as an example, John Doe owns J.D. Frames Corp., which makes specialty truck frames. Doe decides to buy a struggling manufacturer of automobile wheels, Wild Wheels Inc., which he believes he can turn around. In the acquisition year, the frame company generates a profit of $10 million, while the wheel company posts a $5 million loss. If Doe operated those businesses as two completely separate corporations filing separate tax returns, the wheel company would owe no federal income tax but the frame company would owe tax on its $10 million profit. | | Businesses Have Global IDs D&B assigns a unique nine-digit “D-U-N-S” number to nearly every business in the world. The company links the D-U-N-S numbers (recognized as a global business identification standard) of more than 64 million parent companies, their subsidiaries, headquarters and branches around the world. In the United States suppliers doing business with the federal government via electronic data interchange must submit their D-U-N-S number for registration and transaction processes. Source: D&B, Murray Hill, New Jersey, www.dnb.com . | | But what if Doe decided to form a holding company—called Doe Industries Inc.—and structured J.D. Frames and Wild Wheels as its two wholly owned subsidiaries? For federal tax reporting purposes, U.S. companies can file a consolidated return for themselves and all subsidiaries in which they own at least an 80% stake, with certain exclusions for foreign subsidiaries. In this case, filing a consolidated return permits Doe Industries to offset the $10 million profit by J.D. Frames with the $5 million loss posted by Wild Wheels. The net result? Doe’s corporate empire would owe federal income taxes on just $5 million, not $10 million. At a corporate tax rate of 35%, that equals a savings of $1.75 million. To be sure, Doe could simply operate Wild Wheels as an unincorporated division of Doe Industries, in which case any losses by one operation would automatically offset profits in the other—without the complexities of filing a consolidated tax return. However, he would lose some of the legal protections inherent in the subsidiary structure, such as the ability to insulate Doe Industries from the liabilities of Wild Wheels. If he wished to retain those protections and still avoid the consolidated return, Doe could structure Wild Wheels as a subsidiary but for tax reporting purposes consider it a disregarded entity under IRC section 7701. This would allow Doe to treat the subsidiary as a division of the parent on Doe Industries’ income tax return. STILL MORE TAX RELIEF Forming a subsidiary business structure can also provide tax benefits at the state and international levels. Janet Moran, a tax attorney and partner in the technology, media and telecommunications group at the New York office of Deloitte & Touche LLP, explains that many states tax businesses on all of their income, regardless of where it was generated. But some, such as Pennsylvania and Michigan, allow subsidiaries to file returns that tax only the profits generated within the state’s borders, not those generated by operations in other locations. The same is also true in some states with regard to the collection and filing of sales and use taxes. “Even if you’re filing a consolidated tax return at the federal level, it doesn’t mean that you have to file on a combined basis in every state,” says Moran. “We’re always setting up subsidiaries for clients for state tax purposes.”
| Companies that operate internationally can also set up foreign operations as separate subsidiaries. Typically, the profits of those subsidiaries will then be taxed in the country where the subsidiary is incorporated and will not be subject to U.S. income tax. LEGAL PROTECTION In addition to the tax benefits of forming a subsidiary, many companies crave the legal protections from potential plaintiffs and creditors it can provide. Lee Reicher, CPA, attorney and managing partner of the Los Angeles law firm Reish Luftman McDaniel & Reicher, says that liabilities and creditor claims of a subsidiary are “trapped” in that subsidiary and can’t be passed on to the parent company. As a result, if the subsidiary runs into financial trouble, the parent company’s assets and its credit rating are protected. “Assume you had a construction company that primarily built buildings but on occasion had to do demolition with dynamite, which is very dangerous work,” Reicher says. “You might set up a subsidiary whose only purpose was to do the dynamite work.” As a consequence, he says, even an accident that generated huge claims against the subsidiary, perhaps even threatening its viability, would not threaten the continuity of the parent construction company. But a business doesn’t have to be involved in a risky operation to justify the creation of a new subsidiary. “Any time you’re starting a new venture, there’s always risk of loss,” explains Farra. “You want to protect the profitable part of the business from the losses of the new business you are starting, and by putting the new business into a separate subsidiary, you can do that.” Consider the case of a West Coast media company—one of Reicher’s clients—which formed a subsidiary a few years ago when it decided to enter a new line of business. The venture did not go well, and some creditors were forced to sue for payment of their bills, which were ultimately settled for less than full value. However, the media company itself was shielded from the creditor’s reach by virtue of the subsidiary arrangement. “It was only because we kept it (the new operation) separate that we confined the contagion to the unit and didn’t wind up infecting the rest of the company,” says the owner, who requested anonymity. SATISFY OTHER OBJECTIVES A company can create a subsidiary to fulfill other aims (see “Is It Time to Establish a Subsidiary?” at right). In the case of the West Coast media company, for example, its goal was not merely to shield itself from possible financial fallout from its new venture; it also wanted to tie the performance-based pay of the new venture’s manager to the performance of that venture alone, not the company as a whole, and retain the flexibility to easily sell the subsidiary at a later date if that became an attractive option. The company was able to satisfy both these objectives by setting up the new venture as a separate legal entity with its own set of books. | | Is It Time to Establish a Subsidiary? CPAs can offer this checklist to company management to help determine whether it should set up a subsidiary. A “yes” answer to any of the questions indicates that forming a subsidiary may be in order:
Lewgal issues Is there a chance the company can be sued? Is the magnitude of the liability exposure in a particular area of the business high? Does the company produce a dangerous product or render a dangerous service? Is the company in a litigious industry? 
Is it prudent to isolate multiple products or businesses for a bank credit rating?
Are there plans to raise new capital to expand a specific portion of the company? Do investors want to invest in only part of the company?
Are there plans to sell only a portion of the business?
Will there be a distribution of various segments of the business to family members?
Can the company enhance the profile of a product by using the same name for a marketing benefit but keep products in segregated divisions?
Will the company award stock options in only one product or stock options in different products and divisions to different employees?
Are there government benefits (set-asides for minority-owned businesses) available based upon certain share ownership criteria such as 51% ownership by a demographic segment?
Are there beneficial tax consequences based on different geographic locations such as discrete operations in separate states or countries?
Will any of the above questions receive a “yes” answer in the next five years? (If so, for tax reasons the subsidiary to be split off needs to be in operation for five years to avoid ordinary income tax treatment on sale.) Source: Lee Reicher, CPA, is an attorney and managing partner at the Los Angeles law firm Reish Luftman McDaniel & Reicher, www.reish.com . | | Other reasons to form a subsidiary include facilitating the implementation of different nonqualified benefit plans for individual business operations and their managers and creating joint ventures with other companies with each owning a portion of the new operation. “I even had a company—and this is probably not so uncommon—that just wanted to give somebody a new title,” Moran says. “Management said, ‘We’ve got to make him president of something,’ so they created a new subsidiary.” She also once helped a company create a subsidiary solely to house intangible assets—copyrighted material that the company licensed to customers—at the request of the company’s bank. The bank wanted those assets isolated in a separate legal entity where they would be protected and unencumbered by other potential liabilities, Moran says. Sometimes, companies will want to form subsidiaries to take advantage of tax and regulatory benefits unique to their industry. In the life insurance industry, for example, mutual-owned life insurance companies often set up a mutual holding company and then put their operating units into subsidiaries that are structured as stock life insurance companies, says Peggy Scott, CPA, CFO of Pan-American Life Insurance Co. in New Orleans. By doing so, the insurance companies avoid the negative impact of IRC section 809(a), which reduces, by a complex formula, the amount of the tax deduction allowable under IRC section 808 for policyholder dividends paid by mutual companies. Using the subsidiary structure also minimizes the complexity of dealing with insurance regulations that vary from state to state, Scott says. AND FOR THE WRONG REASONS Given the benefits associated with forming subsidiaries, it’s not surprising that virtually all sizable companies use them. It’s also not surprising that companies sometimes misuse them. “The classic case that almost everybody reads in law school is about New York taxi cabs,” says Reicher. “A cab company put every one of its taxis in its own separate corporation on the theory that if one cab was in an accident, there would be nothing in that corporation for a plaintiff to go after except an old beat-up taxi cab.” When tested in court this application of subsidiary law didn’t hold up. Instead, says Reicher, the plaintiff’s attorneys successfully argued that the individual cabs were not individual companies, but merely extensions of a parent company in which all dispatching and bookkeeping operations were conducted on a centralized basis. Enron Corp. came under fire for its aggressive use of subsidiaries in what now appears to have been an attempt to avoid U.S. taxes and hide high-stakes deals from investor scrutiny. According to its 2000 annual report, Enron operated a network of 2,000 corporate subsidiaries in 23 states and 62 countries, including offshore tax havens such as the Cayman Islands. While there is nothing illegal per se about such subsidiaries, Enron ran into accounting trouble with several special purpose entities it created to keep debt off its balance sheet. Special purpose entities are any type of corporate entity, such as a limited liability corporation or limited partnership, created for a specific transaction or business that is usually unrelated to a company’s main business. In Enron’s case, it created off-balance-sheet partnerships run by its CFO. In some cases, however, it still controlled those entities and even backed their debts, sometimes with notes convertible into Enron shares. In the third quarter of 2001, the company reported a $618 million loss—the stock price plummeted and shareholder equity shrank by $1.2 billion—caused, in part, by problems at the off-balance-sheet partnerships. Shortly afterwards Enron filed for protection from creditors under Chapter 11 of the federal bankruptcy code. POSSIBLE PITFALLS Of course a subsidiary structure isn’t always right for every company and its owners. Reicher recalls working with a client who operated a large and successful retail store and decided to open another one in a different location. Reicher argued for putting the second store in its own subsidiary, both for the liability protections and to make it easier to sell the second location at a later date should the owner decide to do so. “They were both good reasons, and the owner even agreed,” Reicher recalls. “But he decided not to do it because he didn’t want the hassle” of filing the necessary legal paperwork and maintaining a separate set of books. The kicker, Reicher says, is that it wouldn’t have been much of a hassle. “All he would have needed was a separate set of books for each store for tax-reporting purposes, and he was keeping separate books for the two stores anyway for cost-accounting purposes,” Reicher says. In yet another case, Reicher says, a client who did operate two separate companies engaged him to merge them into one company to facilitate their sale. One of the subsidiaries was profitable, he notes, the other wasn’t, and the client didn’t want a buyer cherry-picking the profitable business and leaving him stuck with the money-loser. Although merging the two businesses wouldn’t obligate a buyer to take both, he says, the client believed he would have a better chance of selling them as a package if they were organized as a single entity. Even in legitimate applications where creating a subsidiary will clearly help to achieve corporate aims, companies and their advisers structure the deal so it won’t run afoul of federal tax, employment and benefit regulations. For example, while offering employees in individual subsidiaries different nonqualified benefits such as stock options is perfectly acceptable, offering them different qualified plans such as pension or profit-sharing vehicles subject to the Employee Retirement Income Security Act of 1974 requires careful drafting. In practice, most qualified plans are written to cover a certain class of employee such as “all nonunion employees” or “all manufacturing employees.” Unless a plan specifically limits participation to employees in a specific locale, those employed by a subsidiary—even those engaged in a different line of business in a different part of the country—are typically covered by it and cannot be excluded. Subsidiaries can, as independent legal entities, borrow money and even issue their own debt. But if they arrange for their parent company to guarantee a loan, their independence—and the legal protections that go with it—are compromised. “A guarantee blows away the liability protection because by contract the subsidiary has had somebody else (the parent) say, ‘I’ll be good for their debt,’” says Reicher. Companies and their CPAs also must be careful when booking intercompany transfers to and from subsidiaries that are not being included in a consolidated tax return, as would be the case with a less-than-80%-owned subsidiary or most foreign subsidiaries. Moran recalls one company that had formed unconsolidated subsidiaries and then sent them money as needed. Unfortunately, it classified the transfers as loans. “They were actually capital contributions, and as such, the company wasn’t charging interest,” she says. “But when the IRS reviewed their tax returns, the agency said, ‘Oh, you’ve made a loan, where are the interest payments?’” The company ultimately was able to explain the payments weren’t loans, but only after the misunderstanding had led to an expensive audit. Moran also notes IRS regulations require that all intercompany transactions be priced as if they were done at arm’s length and satisfy a legitimate business interest, not just a tax objective. SIMPLE MECHANICS The steps involved in creating a subsidiary aren’t, by themselves, that complicated (see “The Mechanics of Forming a Subsidiary,” below). CPAs who advise employers or clients on the matter should have a strong grounding in tax regulations, particularly those relating to intercompany transfers of assets or liabilities. They also should be able to clearly delineate the many advantages that a subsidiary structure can offer, particularly to management teams or owners who may be leery of introducing added complexity into their operations but need to take a fresh look at their business strategies. For most companies expanding their operations to include new lines of business or to operate in new locations, creating a subsidiary is a cost-effective undertaking that can yield substantial tax and liability benefits.
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