A subsidiary company is a distinct legal entity owned and controlled by a separate, larger corporation known as the parent company. While the parent directs the overall strategy, the subsidiary operates with its own assets, liabilities, and management structure. This guide provides a step-by-step framework for establishing a subsidiary, covering strategic planning, legal formation, and operational setup.
Strategic Reasons for Creating a Subsidiary
A primary reason to form a subsidiary is to insulate the parent company from financial and legal risks. Because a subsidiary is a separate legal entity, any debts or lawsuits it incurs are contained within that new company. This separation protects the parent’s core assets, which is valuable when venturing into high-risk industries. If the new venture fails, the financial damage is ring-fenced from the primary business.
Expansion into new geographic markets is another common motivator. A subsidiary can be tailored to navigate the specific regulatory landscape and tax laws of a new region. This structure facilitates catering to local market demands with customized products or services. This signals a long-term commitment to the market and enhances credibility.
Subsidiaries also organize and streamline complex business operations. A large corporation might create separate subsidiaries to manage distinct business lines, such as manufacturing and sales. This separation allows for more focused management and clearer financial reporting. It can also be used to build a distinct brand identity separate from the parent company.
Choosing the Right Business Structure
The two most common structures for a subsidiary are the Limited Liability Company (LLC) and the C Corporation. An LLC is often favored for its flexibility and simpler compliance requirements. Its primary advantage is pass-through taxation, where the subsidiary’s profits and losses are passed directly to the parent company’s tax return, avoiding double taxation.
A C Corporation is a separate taxable entity that files its own corporate tax return. When profits are distributed to the parent company as dividends, the parent may also be taxed on that income. However, C Corporations offer a rigid governance structure with a board of directors and officers, which can be advantageous for attracting investment.
Both structures create a legal barrier, or “corporate veil,” that separates the subsidiary’s liabilities from the parent company’s assets. The administrative burden of a C Corporation, with its requirements for regular board meetings and formal record-keeping, is higher than that of an LLC.
Naming and Location Considerations
Selecting a name for the subsidiary is a foundational legal step. The chosen name must be unique and not already in use by another business in the state of formation. Most states provide an online database through the Secretary of State’s office to check for name availability. The name must also include an identifier, such as “LLC” for a Limited Liability Company or “Inc.” for a corporation.
Where to form the subsidiary is also important. Many businesses form their subsidiary in the state where it will conduct its primary operations for simplicity. This aligns the company with local laws from the outset.
An alternative is to form the subsidiary in a state known for its business-friendly legal framework, such as Delaware. Delaware is popular due to its established corporate law and a specialized court for business disputes. While this offers advantages, the subsidiary must also register as a “foreign” entity where it operates, adding administrative complexity.
Executing the Legal Formation
Appoint a Registered Agent
Every state requires a corporation or LLC to have a registered agent to receive official legal and government correspondence. The agent must have a physical street address in the state of formation and be available during business hours. Parent companies can appoint an individual from within the subsidiary or hire a professional service.
File Formation Documents
File formation documents with the appropriate state agency, usually the Secretary of State. For a C Corporation, this is the Articles of Incorporation; for an LLC, it is the Articles of Organization. This document legally creates the subsidiary and includes its name, registered agent, business purpose, and authorized shares (for a corporation).
Obtain an Employer Identification Number (EIN)
As a new legal entity, the subsidiary must obtain its own Employer Identification Number (EIN) from the IRS. An EIN is a unique nine-digit number required for filing taxes, opening a bank account, and hiring employees. The application is free and can be completed online via the IRS website.
Draft Governing Documents
Internal governing documents set the rules for how the subsidiary operates. For a C Corporation, these are the corporate bylaws, outlining procedures for board meetings and electing officers. For an LLC, the operating agreement details members’ rights, profit distribution, and management structure. These are legally binding internal records not filed with the state.
Issue Ownership to the Parent Company
Formally document the parent company’s ownership of the new subsidiary. For a C Corporation, issue shares of stock to the parent company and record the transaction. For an LLC, issue a membership interest to the parent company as detailed in the operating agreement. This step solidifies the parent-subsidiary relationship.
Funding and Capitalizing Your Subsidiary
Once legally formed, the subsidiary needs capital to operate, which the parent company provides through a capital contribution. This involves the parent transferring cash or assets to the subsidiary for its ownership stake. This initial investment should be formally documented to support the legal separation between the two entities.
Opening a dedicated bank account in the subsidiary’s name is a required step. All of the subsidiary’s financial activities must be conducted through this separate account. Use the subsidiary’s own EIN and legal name to open the account to reinforce its status as a distinct entity.
Co-mingling funds between the parent and the subsidiary is prohibited. Sharing bank accounts or using the parent’s account to pay the subsidiary’s expenses can undermine the legal separation of the entities. This practice can allow creditors to pursue the parent company’s assets.
Establishing Governance and Management
With the subsidiary formed and funded, a governance structure must be put in place. For a C Corporation, the parent company, as the shareholder, appoints the subsidiary’s initial board of directors. The board is responsible for overseeing strategy and then appoints officers, such as a CEO and CFO, to manage daily operations.
For an LLC, the governance structure is outlined in the operating agreement. The parent company determines if the subsidiary will be “member-managed” or “manager-managed.” In a manager-managed LLC, the parent appoints managers to run the business, who function similarly to corporate officers.
While the parent company holds control, it is important to establish a distinct management team for the subsidiary. This team should be responsible for its own operational decisions, reinforcing the separation between the two entities.
Maintaining Corporate Separateness
The liability protection offered by a subsidiary depends on maintaining a strict legal separation from the parent company, known as the “corporate veil.” If a court finds the subsidiary is merely an “alter ego” of the parent, it can pierce the corporate veil. This holds the parent company liable for the subsidiary’s debts, negating a core benefit of the structure.
To prevent this, businesses must observe corporate formalities. The subsidiary must hold its own, separate board of directors or management meetings and keep detailed minutes of those proceedings. All major decisions related to the subsidiary should be approved and documented at the subsidiary level, not by the parent’s board.
Financial independence is another pillar of corporate separateness. The subsidiary must maintain its own bank accounts, financial statements, and accounting records, and never co-mingle its assets with the parent. All contracts, invoices, and agreements must be signed in the legal name of the subsidiary, not the parent.
Adhering to these practices ensures the subsidiary is treated as a distinct entity in the eyes of the law. This preserves the protective barrier for the parent company.