By Nellie Akalp
A holding company cannot be held responsible for the legal or financial problems of its subsidiaries.
A holding company is a legal business entity (usually a limited liability company or C Corporation) that owns or has controlling interest in one or more companies (called “subsidiaries”). Other terms for a holding company include “parent company” and “umbrella company.” Regardless of the wording, a holding company helps protect the assets of its individual subsidiaries and limit liability risks across all of its subsidiaries.
In addition to owning other business entities, a holding company may also own other assets, such as:
- Shares and securities
- Patents
- Trademarks
- Copyright
- Real estate
Why form a holding company, what is the relationship between a holding company and its subsidiaries, and what type of entity is best for a holding company? We will discuss these considerations in this article. I also encourage business owners to seek legal and tax guidance from an attorney and professional accountant to help them make informed decisions about structuring multiple businesses.
Relationship between a holding company and its subsidiaries
Each subsidiary under a holding company is established as its own separate company. Thus, if the subsidiaries are incorporated as corporations or limited liability companies (LLCs), each must file an article of incorporation or bylaws with the state, have its own articles of incorporation or LLC operating agreement, have its own bank accounts, operate its own payroll and keeps its own financial records.
Typically, a holding company acts as the owner and manager of its subsidiary entities, but has no direct operations associated with them. Each subsidiary has its own management to run the day-to-day business, while the management of the holding company owns its assets and oversees the policies and decisions of the subsidiaries. Generally, the activities of a subsidiary do not affect the activities of other subsidiaries of a holding company.
Advantages of a holding company
Reduce liability
Entrepreneurs typically form a holding company to limit liability risks when they own multiple businesses. Each affiliate is protected from the legal claims and debts of the other affiliates.
Likewise, a holding company cannot be held responsible for the legal or financial problems of its subsidiaries, provided that it has not actively participated in the activities of those subsidiaries or guaranteed the subsidiary’s debt. However, if the holding company or its subsidiaries pierce the corporate veil – e.g. committed fraud, were negligent in some way, or failed to comply with their entity’s state compliance requirements – the holding company, and possibly the holding company’s owners, may be at legal or financial risk.
Attracting investors
There could also be funding and development advantages. Because the subsidiaries under a holding company are their own legal entities and are shielded from the liability of the other subsidiaries, it may be easier to attract investors or partners for these individual businesses than if they were all incorporated as a single entity with multiple divisions.
And, if the holding company seeks financing, it may be able to obtain a loan at a lower interest rate than the individual holding companies because of its strong financial position.
Optimize tax efficiency
Generally, C Corporation subsidiaries file their own tax returns and pay dividends to their holding company without creating a tax liability for the parent corporation as would happen if those dividends were paid to individuals. The holding company can then distribute these profits to its shareholders or reinvest them in its other subsidiaries – choosing what is optimal for its tax and growth objectives.
Alternatively, the profits, losses and tax liabilities of subsidiaries that are considered disregarded entities (eg, LLCs, partnerships) for tax purposes are reported through a consolidated federal income tax return filed by the holding company.
C Corporation subsidiaries may also be reported on a consolidated return if they file IRS Form 1122 (Authorization and consent of subsidiary company to be included in consolidated income tax return).
If a holding company files a consolidated tax return, the profits of one or more subsidiaries can be offset by the losses of others. This can help reduce the tax burden collectively for the companies under the parent company.
Note that while subsidiaries do not have to file their own federal tax returns when they are part of the holding company’s consolidated return, they may have to file their own state-level returns. State tax laws vary, so it’s important to research the rules that apply to your state. For example, an LLC holding company (not taxed as an S-Corp) in California would still be required to file a separate Form 568 (Limited Liability Company Income Return) for each subsidiary LLC.
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C Corporation or LLC as a holding company?
There is a lot to consider when structuring multiple businesses under a holding company. First and foremost is what type of entity to choose for the parent company.
C Corporation
AC Corporation is a separate legal and tax entity from its owners (shareholders). As such, it offers the benefit of personal liability protection as all actions of the company are linked to the company and not to its owners. For entrepreneurs who envision business growth, the C Corp structure allows capital to be raised by issuing or selling stock. Also, a C Corp has perpetual existence under state law, so a parent corporation that is incorporated can survive indefinitely (until it is officially dissolved).
Basic Steps to Forming and Maintaining a C Corporation
- Appoint a registered agent
- Statute file
- Get an EIN
- Appointment of board of directors
- Adoption of statutes
- Apply for licenses and business permits
- Open a business bank account
- Conducting board meetings
- Conducting shareholder meetings
- Submit an annual report
Some potential disadvantages of forming a C Corporation as a holding company include more paperwork to register the entity and more extensive compliance formalities—eg. approving regulations, holding board meetings, holding shareholder meetings, submitting annual reports, etc. Requirements for registering and maintaining a C Corporation vary by state.
And then there’s double taxation—income is taxed at the corporate level when it’s earned by the company, and then again at the individual level when distributions are paid out to shareholders.
Limited liability company
A limited liability company also protects its owners (known as “members”) from personal liability. Additionally, it does not have as extensive compliance requirements as a C Corporation.
Basic Steps to Forming and Maintaining an LLC
- Appoint a registered agent
- Archiving articles of organization
- Get an EIN
- Create an LLC operating agreement
- Apply for licenses and business permits
- Open a business bank account
- Conduct member meetings (if required by LLC operating agreement)
By default, an LLC is taxed as a disregarded entity and all profits and losses flow to the owners of the business. However, if he meets the IRS eligibility requirements, he can elect S Corporation or C Corporation tax treatment. Compliance requirements vary by state, but typically an LLC does not need to have an annual meeting or board of directors unless its operating agreement states otherwise.
Some potential disadvantages to operating as an LLC are that it cannot issue stock to raise capital and may not have as many tax deductions as a C Corporation. Also, unless the LLC’s operating agreement includes perpetual existence provisions, state law may require that an LLC be dissolved if one or more of its members die or leave the company.
Moving existing LLCs or companies under a holding company
In the event of a change in ownership of a C Corporation from individuals to a holding company, the procedures outlined in that corporation’s bylaws should be followed. If the holding company is a corporation, this may involve a stock-for-stock exchange in which shareholders exchange their shares in the operating company for shares in the holding company (assuming the shareholders are the same in the operating company and in the holding company).
If ownership of an LLC changes from individuals to a holding company, the procedures outlined in the LLC’s operating agreement must be followed to make that change. Typically, this involves creating a buyout or liquidation of the operating LLC to change ownership from the individual(s) to the holding company.
Things get more complicated with an operating LLC taxed as an S Corporation Shareholders of an S Corporation can only be individuals, a certified single member LLC, certain trusts, estates, and certain exempt organizations. In other words, the shareholders of an S Corporation cannot be a partnership or corporation unless the operating S Corporations qualify for the QSub (qualified subchapter S) election. The QSub election basically allows QSubs to be treated as disregarded entities for federal income tax purposes and to collapse into a holding company that is a partnership or corporation.
Choosing the right business structure
Structuring multiple businesses can be complicated from a tax and legal perspective. It is important to get guidance from professionals who can help you understand your options and how they will affect you and your companies.
About the Author
Nellie Akalp is a passionate entrepreneur, business expert, professional speaker, author and mother of four. She is its founder and CEO CorpNet.coma trusted provider of resources and services for business incorporation, LLC filing and corporate compliance services in all 50 states.
