By Nellie Akalp
A holding company cannot be held liable for its subsidiaries’ legal or financial problems.
A holding company is a legal business entity (usually a limited liability company or C Corporation) that owns or has a 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 to protect its individual subsidiaries’ assets and limit liability risks across all of its subsidiaries.
Besides owning other business entities, a holding company may also own other assets, such as:
- Stock and securities
- Patents
- Trademarks
- Copyrights
- Real estate
Why form a holding company, what’s the connection between a holding company and its subsidiaries, and what entity type is best for a holding company? We’ll discuss those considerations in this article. I also encourage business owners to seek legal and tax guidance from an attorney and accounting professional 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 set up as its own separate company. So, if subsidiaries are formed as corporations or limited liability companies (LLCs), each one must file articles of incorporation or articles of organization with the state, have its own set of bylaws or LLC operating agreement, have its own bank accounts, run its own payroll, and maintain its own financial records.
Typically, a holding company serves as the owner and administrator of its subsidiary entities but has no direct operations tied to them. Subsidiaries each have their own management for running the day-to-day business, while the holding company’s management owns its assets and oversees the subsidiaries’ bigger-picture policies and decisions. Generally, one subsidiary’s activities do not affect a holding company’s other subsidiaries’ activities.
Advantages of a holding company
Lessen liability
Entrepreneurs typically form a holding company to limit liability risks when owning multiple businesses. Each subsidiary is protected from the legal claims against and debts of the other subsidiaries.
Likewise, a holding company cannot be held liable for its subsidiaries’ legal or financial problems, provided it has not actively participated in the operations of those subsidiaries or guaranteed debts of the subsidiary. However, if the holding company or its subsidiaries pierce the corporate veil—e.g., committed fraud, were negligent in some way, or didn’t follow through on their entity compliance requirements with the state—the holding company, and possibly the holding company’s owners, might be at risk legally or financially.
Attract investors
There could be funding and growth advantages, too. Because the subsidiaries under a holding company are their own legal entities and protected from the liability of the other subsidiaries, it may be easier to attract investors or partners for those individual businesses than if all were set up as a single entity with many divisions.
And, if the holding company seeks financing, it may be able to obtain a loan with a lower interest rate than its individual operating companies because of its robust financial position.
Optimize tax efficiency
In general, C Corporation subsidiaries file their own tax returns and pay dividends to their holding company without creating a tax liability for the parent company as it would if those dividends were paid to individuals. The holding company can then disburse those profits to its shareholders or reinvest them in its other subsidiaries—choosing what’s optimal for their tax and growth goals.
Alternatively, the profits, losses, and tax liabilities of subsidiaries regarded as disregarded entities (e.g., LLCs, partnerships) for tax purposes get reported via a consolidated federal tax return filed by the holding company.
C Corporation subsidiaries can also be reported on a consolidated return if they submit IRS Form 1122 (Authorization and Consent of Subsidiary Corporation To Be Included in a 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. That can help lower the tax burden collectively for the companies under the parent company.
Keep in mind that while subsidiaries don’t have to file their own federal tax returns when they’re part of the holding company’s consolidated return, they may have to file their own returns at the state level. States’ tax laws vary, so it’s critical to research the rules that apply to your situation. 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 Return of Income) for each subsidiary LLC.
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C Corporation or LLC as a holding company?
There’s much to consider when structuring multiple businesses under a holding company. First and foremost is what entity type to choose for the parent company.
C Corporation
A C Corporation is a separate legal and tax-paying entity from its owners (shareholders). Therefore, it offers the advantage of personal liability protection as all actions of the corporation are tied to the corporation, not its owners. For entrepreneurs who envision growing the business, the C Corp structure allows for raising capital by issuing or selling stock. Also, a C Corp has perpetual existence under state law, so an incorporated parent company can survive indefinitely (until it’s formally dissolved).
Basic steps for forming and maintaining a C Corporation
- Designate a registered agent
- File articles of incorporation
- Obtain an EIN
- Appoint a board of directors
- Adopt bylaws
- Apply for business licenses and permits
- Open a business bank account
- Hold board of directors’ meetings
- Hold shareholder meetings
- File an annual report
Some potential downsides of forming a C Corporation as a holding company are more paperwork involved to register the entity and more extensive compliance formalities—e.g., adopting bylaws, holding board of directors’ meetings, holding shareholder meetings, filing annual reports, etc. The specific requirements for registering and maintaining a C Corporation vary by state.
And then there’s the double taxation—income is taxed at the corporate level when it’s earned by the corporation and then again at the individual level when distributions are paid to shareholders.
Limited liability company
A limited liability company protects its owners (known as “members”) from personal liability, too. Moreover, it doesn’t have as extensive compliance requirements as a C Corporation.
Basic steps for forming and maintaining an LLC
- Designate a registered agent
- File articles of organization
- Obtain an EIN
- Create an LLC operating agreement
- Apply for business licenses and permits
- Open a business bank account
- Hold member meetings (if required by the LLC operating agreement)
By default, an LLC is taxed as a disregarded entity, and all profits and losses flow through to the business owners. However, if it meets the IRS’s eligibility requirements, it may 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 a board of directors unless its operating agreement states otherwise.
Some potential drawbacks to operating as an LLC are that it cannot issue stock to raise capital, and it may not have as many tax deductions as a C Corporation. Also, unless the LLC’s operating agreement has provisions for perpetual existence, state law may require an LLC to be dissolved if one or more of its members dies or leaves the company.
Moving existing LLCs or corporations under a holding company
If changing ownership of a C Corporation from individuals to a holding company, the procedures described in that corporation’s bylaws should be followed. If the holding company is a corporation, that might involve a share-for-share exchange whereby the shareholders swap their shares in the operating company for shares in the holding company (presuming the shareholders are the same in the operating corporation and the holding corporation).
If changing ownership of an LLC from individuals to a holding company, the procedures described in the LLC’s operating agreement should be followed to make that change. Usually, that entails 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 The shareholders of an S Corporation may only be individuals, a qualified single-member LLC, certain trusts, estates, and certain exempt organizations. In other words, the shareholders of an S Corporation cannot be a partnership or a corporation unless the operating S Corporations qualify for QSub (qualified subchapter S subsidiary) election. QSub election basically allows QSubs to be treated as disregarded entities for federal income tax purposes and be collapsed into a holding company that’s a partnership or a corporation.
Choosing the right business structure
Structuring multiple businesses can be complex from a tax and legal standpoint. It’s essential to get guidance from professionals who can help you understand your options and how they will impact you and your companies.
About the Author
Nellie Akalp is a passionate entrepreneur, business expert, professional speaker, author, and mother of four. She is the founder and CEO of CorpNet.com, a trusted resource and service provider for business incorporation, LLC filings, and corporate compliance services in all 50 states.
