A subsidiary company is an entity that is owned or controlled by another company, referred to as a parent or holding company. While the parent company holds a controlling interest, the subsidiary operates as a distinct legal entity, responsible for its own operations and liabilities. This structure allows a business to expand its operations or enter new ventures without creating an entirely new organization from the ground up.
Reasons to Form a Subsidiary Company
One of the most common drivers for creating a subsidiary is to protect the parent company’s assets from the liabilities of a new venture. Because a subsidiary is a separate legal entity, its debts, legal claims, and financial issues are contained within it. This separation shields the parent company’s core assets, providing financial protection should the new business face challenges. This structure is particularly useful when venturing into higher-risk industries or new markets.
Subsidiaries are also an effective tool for strategic expansion and market entry. A parent company can establish a subsidiary to operate in a new geographic location or a completely different industry. This allows the core business to diversify its interests and tap into new revenue streams without diluting its primary focus. For foreign companies entering the U.S. market, creating a U.S. subsidiary can enhance credibility with local customers and partners.
This structure also facilitates distinct brand identities and targeted management. Large corporations often use subsidiaries to house different products or brands, each with its own unique identity and market strategy. For example, The Walt Disney Company operates ESPN as a subsidiary, allowing each brand to maintain its specific focus. This separation allows for dedicated management teams to concentrate on the specific operational needs of each business line.
Choosing a Business Structure for the Subsidiary
Selecting a legal structure is a foundational step that dictates the subsidiary’s taxation, liability, and administrative requirements. The two most common options are the Limited Liability Company (LLC) and the C Corporation (C-Corp). The choice depends on the parent company’s strategic goals for the new entity.
An LLC is often favored for its operational flexibility and tax advantages. By default, an LLC offers pass-through taxation, meaning its profits and losses are passed to the parent company and reported on the parent’s tax return. This avoids the double taxation issue present with corporations.
A C-Corp is a separate legal and taxable entity from its owners. This means the subsidiary is taxed on its own profits, and the parent company may be taxed again on dividends it receives, a situation known as double taxation. However, C-Corps are the most common structure for subsidiaries intending to seek investment or eventually go public, as the structure is well-understood by investors and provides a clear framework for corporate governance.
The Legal Formation Process
Select a Name and Registered Agent
The formation process begins with selecting a unique name for the subsidiary, which must be distinguishable from any other business entity registered in the state of formation. A thorough trademark search is also recommended to ensure the chosen name does not infringe on existing brands.
Next, you must appoint a registered agent, which is a person or service designated to receive official legal and government correspondence. The registered agent must have a physical street address in the state of incorporation. This agent is responsible for forwarding any service of process to the company’s leadership, ensuring the business is properly notified of legal matters.
File Formation Documents
With a name and registered agent selected, the next step is to file official formation documents with the secretary of state in the chosen state. If the subsidiary is structured as a corporation, you will file “Articles of Incorporation.” If it is an LLC, the document is called “Articles of Organization.”
These documents formally create the legal entity of the subsidiary. They include basic information such as the subsidiary’s name, the registered agent’s details, the business purpose, and the name of the parent company as the owner.
Draft Governing Documents
After the state approves the formation, you must draft the subsidiary’s internal governing documents. For a C-Corp, this document is known as corporate bylaws; for an LLC, it is called an operating agreement. These internal documents outline how the subsidiary will be managed and governed.
The bylaws or operating agreement will detail the roles and responsibilities of the leadership, how profits and losses will be distributed, voting rights, and procedures for meetings. It will also formally state that the subsidiary is owned by the parent company, clarifying the ownership structure and providing a roadmap for decision-making.
Appoint Leadership
The parent company must appoint the initial leadership of the subsidiary. For a corporation, the parent company, as the shareholder, will appoint the initial board of directors. The board is then responsible for overseeing the subsidiary’s strategy and appointing officers, such as a CEO and CFO, to manage daily operations.
For an LLC, the parent company, as the member, will appoint the subsidiary’s managers, and the operating agreement will define their authority. It is permissible for directors or officers of the parent company to also serve in leadership roles at the subsidiary, but their decisions must be made in the best interest of the specific entity they are representing.
Post-Formation Financial and Operational Steps
The first action is to obtain a federal Employer Identification Number (EIN) from the IRS. The EIN is a unique nine-digit number that acts as a Social Security number for the business. It is required for tax filings, opening bank accounts, and hiring employees.
Next, you must open a separate bank account in the subsidiary’s name. This account must be used for all of the subsidiary’s financial activities, including receiving revenue and paying expenses.
The parent company must then formally capitalize the subsidiary, which means providing it with the initial funds or assets needed to begin operations. This transfer of capital, whether it’s cash, equipment, or intellectual property, should be officially documented as an investment or a loan from the parent to the subsidiary.
Maintaining Corporate Separation
To ensure the liability protection offered by a subsidiary remains intact, the parent company must diligently maintain a strict separation between the two entities. This legal distinction is often referred to as the “corporate veil.” If courts find that the parent and subsidiary are not operating as separate entities, they may “pierce the corporate veil” and hold the parent company liable for the subsidiary’s debts.
Maintaining this separation involves several ongoing practices. Each company must keep its own meticulous financial records, and funds between the two should never be commingled. The subsidiary should hold its own board meetings and keep separate minutes, and all contracts and leases should be signed in the name of the correct entity.