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
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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.
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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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