What is a subsidiary?

A subsidiary is like a tool in a Swiss Army knife...

Each tool in a Swiss Army knife has a specific purpose. Together, all of those tools make you ready for almost anything. Likewise, a subsidiary company serves a specific purpose for its parent company, making that parent company more valuable.

A company becomes a subsidiary company when a holding company purchases more than half of its shares. A subsidiary company may have more than one owner, but it can only have one parent company. When a parent company owns 100% of a subsidiary, the subsidiary is referred to as a “wholly owned subsidiary.”

Subsidiaries may also be the parent company of other subsidiaries. Some large company structures can entail many layers of subsidiaries.

Large corporations may have several layers of subsidiaries across the United States and the world. In addition to owning subsidiaries in its home country, Microsoft Corporation owns several subsidiaries across the world to run the operations in specific countries. For example, Microsoft de Argentina S.A. in Argentina and Microsoft Deutschland GmbH in Germany.

A subsidiary company is a means to achieve a parent company’s objectives. Some common reasons a parent company will choose to set up or purchase a subsidiary are:

• Tax benefits: A parent company may offset the profit it receives from one subsidiary with the loss from another and effectively reduce its taxable income. Also, some states offer more tax breaks than others. So, a subsidiary may be set up in a different state than that of its parent company to capitalize on a state tax perk.
• Streamlined operations: A country- or region-specific subsidiary may oversee the day-to-day functions of the local operations much more efficiently than the parent company on the other side of the world.
• Reduced liability: By assigning ownership and management of some assets to its subsidiaries, the parent company generally keeps the liability that comes with owning those assets in the subsidiary. In the commercial real estate industry, a parent company often sets up a limited liability company (LLC) as a subsidiary to purchase and operate a large asset such as a cold storage warehouse or a downtown office building.
• Specific assets: Sometimes, a subsidiary is purchased to obtain assets that are not tangible. A parent company doesn’t have to try and replicate a successful formula when it can just buy a company with that specific asset and set it up as its subsidiary.

To set up a subsidiary, the parent company has to own more than half of the shares of the subsidiary. An essential feature of a subsidiary is that its parent company has control over its operations.

If ownership is less than half in a company, then that company is not considered a subsidiary and is referred to as an associate or affiliate company. This is an important distinction because the financial reporting rules for a subsidiary company differ from those of an associate company.

A best practice is to seek the advice of a certified public accountant (CPA) with experience in transfers of assets and liabilities between companies and knowledge of both the federal tax code and state tax code of the states applicable to the parent company and subsidiary company.

The assets and liabilities of the parent company are typically separate from those of the subsidiary, protecting from liability and creditor claims. This means, among other things, that creditors of the subsidiary usually cannot go after the assets of the parent company if the subsidiary were to default on a loan.

First of all, the current management of the parent company has to authorize the formation of a subsidiary. The entire process should be well documented, and a vote called to decide on the establishment of the subsidiary. Once management reaches the majority vote approving the formation, the director of the company formalizes the decision in a signed document.

The two most common types of business entities for subsidiaries are a corporation or an LLC. Both of these business entity types generally provide creditor protection and allow the parent company to have a controlling interest in the subsidiary. Rules affecting the incorporation or organizational set up of an LLC vary per state.

However, there are some common rules, such as choosing a unique name and registering an official mailing address. Consult a certified public accountant (CPA) and contact the website of the office of the secretary of state to find out all relevant details for your state.

A parent company often gains controlling ownership interest of the subsidiary by providing the startup capital to the subsidiary. This equity helps deliver the necessary cash to start operations.

The parent company usually drafts the subsidiary’s bylaws, setting up the official rules for internal management of the subsidiary and outlining the ownership role of the parent company. A common bylaw is prohibiting the changing of bylaws without the approval of the parent company.

Once the parent company elects and installs a board of directors for the subsidiary, the board can act as an independent entity, and operate like a typical independent business.

The subsidiary keeps financial reporting separate from that of the parent company. However, the parent company generally consolidates the accounting statements, such as the balance sheet and income statement, of the subsidiary into those of the parent company.

A subsidiary lets you have your cake and eat it, too — when it is convenient to do so. The parent company has a controlling interest in the subsidiary, ensuring that the board works in the best interest of the parent company, and keeps separate financial reports.

However, the parent company may pool (consolidate) both sets of books to offset profits with losses and reduce applicable income taxes at the state and federal levels.

Besides granting a tax benefit and protection from creditors and those filing a lawsuit against the subsidiary, a subsidiary may provide a parent company with benefits in the form of streamlined operations and competitive advantages through property, equipment, or its R&D department.

One of the most notable advantages of subsidiaries is the opportunity to keep the parent company and subsidiary as separate entities. Through this limited liability, the parent company is generally not legally responsible for the liabilities and debts of the subsidiary.

The parent company’s liability is typically limited to the initial capital that is exchanged for equity and controlling interest in the company. The assets of the parent company are generally shielded against creditors as long as there is a clear distinction between the operations of the parent company and those of the subsidiary.

This calculated investment enables the parent company to continue pursuing other opportunities for growth.

On the other hand, two of the most notable disadvantages are the significant amount of necessary paperwork and bureaucracy that come with a larger organization. To truly keep both entities separate, each board of directors needs to operate independently. This can lead to longer wait times to reach consensus and implement a decision.

Here are some common terms that are similar, yet different than subsidiaries:

• Affiliate or associate: A firm is referred to as an affiliate or associate company when the parent company owns a non-majority stake. A subsidiary has a parent company owning more than half of the company.
• DBA: Unlike a subsidiary, a DBA is not a separate company. It’s the same company “doing business as” (DBA) under a different name.
• Branch or division: A branch or division refers to a part of the company that operates in a location other than the main office. A subsidiary is a separate company.
• Sister company: All sister companies are subsidiaries, but not all subsidiaries are sister companies. A sister company is a subsidiary that is affiliated with another subsidiary because they share the same parent company. However, a parent company may have a single subsidiary. In this case, the subsidiary has no sister companies.
• Holding company: A holding company is a term for a parent company, not a subsidiary. A holding company owns enough stock in a subsidiary to have a controlling interest in the subsidiary, but it does not participate in the subsidiary’s day-to-day activities.