Expanding your business is exciting, but it can also be risky. Every time you open a new branch, you face new financial and legal issues. Your company as a whole may bear the increased risk if the new branch loses money or gets sued.
Corporations can decrease their liability while growing their businesses by using subsidiaries. Subsidiary companies are considered legally separate entities from the companies that own them. A business may choose to own subsidiaries for several important reasons.
This article explains what subsidiaries are, how they work, why companies own them, and how businesses attain them.
What is a subsidiary?
A subsidiary company is a business entity that another company has full or partial ownership over. Typically, a subsidiary is a corporation or a limited liability company (LLC).
Two types of companies have this subsidiary ownership.
- Parent companies have business operations of their own.
- Holding companies are made up of stockholders who own assets. This type of company exists solely to own and manage its subsidiaries.
A company is considered a subsidiary of another company if the parent organization owns more than 50% of its stock. The parent company or holding company uses its majority control voting rights to wield influence over the business operations of the subsidiary company.
When the controlling company has full control (owns 100%) of a company, the owned company is known as a “wholly owned subsidiary company.” However, if a corporation owns less than 50% of another company, the subsidiary is called an “associate company.”
Why do companies create subsidiaries?
A corporation might own a subsidiary company to achieve several benefits.
- Limit liability: Subsidiaries are separate legal entities from the companies that own them. The two companies don’t share legal or financial liability. If a subsidiary company incurs legal fees, for example, the parent company isn’t responsible for those fees.
- Get tax breaks: Multinational corporations use the subsidiary organizational structure to take advantage of tax benefits in different locations. For example, a corporation located in the United States where the corporate tax rate is 21% might have a subsidiary in Hungary where the corporate tax rate is around 9%.
- Experiment with new markets: Some businesses create subsidiaries to experiment with new markets. If the experimental subsidiary fails, the parent company isn’t affected. For example, a software company might open a subsidiary that sells computers. If the subsidiary company fails, the software corporation can still operate as before.
- Buy an existing business for diversification: Another route a company can take if they’re looking to expand into a different market is to buy a subsidiary company already operating within that market. Let’s take the software company from our last example. Instead of creating a computer business, the software company could buy a computer company that’s already successful and then share in the profits.
How does a subsidiary company work?
As briefly explained, a subsidiary company is owned by a parent company or a holding company. However, there are key differences between the two structures.
- Holding companies don’t typically sell services or make products.
- Parent companies conduct their own business and sell products or services
- Holding companies hold investments in a single subsidiary or group of subsidiaries (then, they’re referred to as umbrella corporations).
- A parent company buys or creates a subsidiary to expand its business.
- Holding companies choose the board of directors across their subsidiaries.
- A parent company can assign the subsidiary’s board members who work for the parent company or elect a board of directors from across its subsidiaries.
What is a parent company?
If a company has a majority of shares in a subsidiary and provides services and products to consumers, that business is a parent company. Parent companies are typically large corporations with business operations that buy the controlling interest in a subsidiary or create one themselves.
A parent company might buy a business that offers a certain product or service to broaden its market. However, as a subsidiary, the acquired company remains separate from the parent company.
What is a holding company?
The main function of a holding company is to hold assets. Holding companies generally don’t provide their services or products. Instead, this type of company might own and oversee a selection of subsidiary companies. The holding company may also own other assets, such as real estate or trademarks.
The holding company usually chooses board members from its subsidiary companies.
Accounting for a subsidiary company
A subsidiary company has to record its financial information in accounts that are independent of the parent company because it is legally considered a different company. Subsidiaries also have to have separate bank accounts from their parent companies. Further, any transactions between a subsidiary and its parent company must be recorded.
Subsidiaries have their employer identification numbers (EINs) and keep their financial statements.
If a parent or holding company owns at least 80% of stock shares in its subsidiaries and has 80% of voting power, it can file a consolidated tax return. This often lowers the parent company’s taxes by offsetting financial gains from one subsidiary with losses from another on its financial statement.
As you might expect, consolidating the financial information of several subsidiaries can be difficult. That’s why companies that own several subsidiaries use accounting experts. If your business needs help tracking transactions, Upwork can connect you to the best independent accountants for the job.
Top 10 pros and cons of subsidiary companies
Having a subsidiary company comes with several benefits as well as some drawbacks.
Pros
- Loss management: A subsidiary is responsible for its losses. If a subsidiary goes bankrupt, for example, creditors can’t go after its parent company to collect the subsidiary’s debt.
- Decreased liability: Subsidiaries shield their parent companies from lawsuits and financial liability. If a subsidiary gets sued, the parent company isn’t responsible for things like legal expenses and financial payouts.
- Tax advantages: Because parent companies own most stock shares in subsidiaries, they have to pay taxes on the dividends their stocks generate. Many companies with multiple subsidiaries can offset dividend gains from one of their subsidiaries with losses from another to lower their tax liability.
- Risk reduction: Companies that own subsidiaries limit their risk of bankruptcy. If one of their subsidiaries goes bankrupt, the parent company and the rest of their subsidiaries are typically unaffected.
- Increased efficiency: Splitting up different parts of a company into separate businesses may make each subsidiary easier to manage. Each company has its management team.
- Easy to acquire and sell: If a parent company wants to expand or diversify its business by offering a new product or service, it can acquire a subsidiary that already performs that service. If the subsidiary fails, the parent company can sell it without affecting its other properties.
- Synergy with other corporate subsidiaries: The subsidiary structure lets parent companies benefit from owning separate companies. However, subsidiaries can still work and interact with other companies under the same umbrella company.
Cons
- Legal costs: Setting up a subsidiary can be expensive. When a parent company opens a subsidiary, it has to pay upfront fees to file articles of incorporation and complete other set-up tasks. The parent company may have to provide capital funds for the business. If the parent buys the subsidiary, it also has to buy the shares in the business.
- Greater bureaucracy: Parent companies heavily influence the operations of their subsidiaries. The parent company typically forms a board to manage all of its subsidiaries. The board then makes decisions that influence every subsidiary a parent company owns. This addition to the chain of command can slow down the decision-making process.
- Complex financial statements: Tax consolidation can be complex. Combining tax records from several companies into a parent company’s tax statements is a time-consuming task with a significant amount of paperwork. The process will likely require the expertise of a dedicated tax professional or firm.
- Less control: Even though a parent company sets up a board to make decisions for its subsidiaries, the parent may not have complete control over them. Unless the subsidiary is wholly owned, other corporations or investors can also own a portion of it and influence operations.
Setting up a subsidiary company
If a parent company wants to bring in a subsidiary business, it will either buy a company or create that company. If the parent chooses to buy a company, it must purchase the majority of stock shares for that company.
In the case of a parent company choosing to create its own company, it needs to follow the process for registering a new business (which can vary by location). The parent company also has to pay several fees to incorporate or register the new business.
After the parent company claims ownership of a subsidiary during the incorporation process, it creates a board of directors to manage the subsidiary and any other subsidiaries the parent company owns. Often, directors are chosen from the various subsidiaries a parent company owns.
Legally, the subsidiary is a different company from its parent corporation. Subsidiaries have their business operations and produce their financial records. Even so, the parent company still has to create a consolidated financial statement that includes its subsidiaries’ reports. Any transactions between a subsidiary and the parent company must be documented.
2 examples of subsidiary companies
Consider these two examples of parent companies and their subsidiaries.
- Meta Platforms Inc. (formerly Facebook Inc.) is the parent company that owns Facebook and other companies including Oculus and Instagram.
- Alphabet Inc. is a holding company that was created to manage Google. Google, in turn, has purchased its subsidiaries. YouTube is one of Google’s most famous acquisitions. A business framework in which subsidiaries own other subsidiaries is called a tiered subsidiary structure.
Common questions about subsidiaries
Now, we’ll go over a few common questions related to subsidiary companies.
Are subsidiaries owned by parent companies?
Yes, subsidiaries—sometimes referred to as child companies—are owned by parent companies or holding companies. Subsidiaries are. Parent companies generally have their business operations apart from their subsidiaries. Holding companies generally don’t have their business operations, create products, or provide services.
Do subsidiaries need to be registered?
Yes, just like any other business, a subsidiary needs to be registered in the state or country where it’s located. If the parent company purchases stock in an existing company, the subsidiary is already registered.
Is a franchise considered a subsidiary?
No, a franchise is different from a subsidiary. A subsidiary is a legally independent company owned by a parent or holding company. A franchise is a privately owned small business that contracts with a larger company to sell the corporation’s services or products and use its intellectual property (e.g., trademarks, copyrights).
Let’s consider a national pizza restaurant chain as an example. The franchise owner signs a contract and agrees to pay the corporation a share of the restaurant’s profits in exchange for the right to sell the corporation’s signature pizza products and use its branding.
Accounting and taxation for parent and subsidiary companies
Even though parent organizations own them, subsidiaries are legally separate businesses that file their taxes, including paying income tax for any revenue generated and maintaining their financial books. The subsidiary business structure is a useful tool to help corporations expand their business operations while limiting their liability.
If you’re planning to open or acquire a subsidiary for your business, you may want to hire independent professionals, like accounting specialists, to help you track transactions and manage your legal risks.
