When Should A Contractor Consider Creating a Subsidiary?
07/17/2023What is a Subsidiary?
A subsidiary is a separate legal business entity (Corp., LLC, etc;) that has its own management team, however, is majority owned, by 51% or more, by the primary business. The majority ownership gives the primary business control over the subsidiary’s board for company decision-making and strategy. In this arrangement, your main business is known as the parent company while the sub-company is the subsidiary.
Reasons to Consider Creating a Subsidiary Could Include the Following:
- Diversify the Business - If considering expanding into a new sector, perhaps public work vs. private work. Separate entities could be more efficient operationally and also allow the company to meet construction workforce challenges.
- Financial Benefits - For example, you plan to run a heavy highway construction business and an equipment company. If the companies operate as separate entities then the construction business could pay to lease equipment from the equipment company. This creates an extra deduction for the established construction business while moving income to the equipment company. This could be helpful if it’s in a lower tax bracket. This strategy would not be successful if all work was performed under one company.
- Reduce Risk – A subsidiary strategy can work well if you are considering launching a new venture and are concerned about whether it will succeed. Since a subsidiary is a separate entity, there is a legal and financial separation between it and your primary construction firm. Whereas, if the new venture was included as part of your main construction firm, it would be fully responsible for any losses and debts.
A subsidiary could make even more sense if the new venture has much higher legal risk such as construction work involving bridge work, cranes, etc. Then, you could do all that work under a subsidiary to protect your main firm against potential lawsuits.
- Acquire Another Business - If considering purchasing another construction business with its own management team you could structure the purchased business as a subsidiary run by the current management team. This will preserve the purchased business company culture and processes. If the acquired company is absorbed directly by the existing business, it could risk changing what made the other construction company successful. However, you would still have the final say over important decisions while preserving the value of your acquisition.
Legal and Tax Benefits
A subsidiary combines legal protection with tax benefits. An example would be if the primary business is considering launching a new construction business different from the existing company. For example, expanding from commercial construction into residential construction. It’s possible the new venture would incur losses as it takes time to get off the ground. If the new business was operated under one company, you’d be able to deduct all losses from the new venture against the profits of your existing business. However, the primary business would also be fully responsible for paying any losses and debts from this other business. If the other business runs into financial trouble, it could hurt the credit rating of your established business and your ability to borrow. Additionally, your main construction business would be liable for any legal issues from the new venture.
If instead a subsidiary was established with no connection to your existing firm, you protect your main business against the liabilities and problems of this other venture. However, you wouldn’t be able to claim their losses to reduce the taxes on your other profits.
Potential Drawbacks
Since a subsidiary has its own separate management, this could create bureaucracy and can slow down decision-making. While you ultimately make the decisions for the subsidiary, it may take longer to communicate and make changes versus how you are used to handling decision making in your current firm.
If the new venture fails and files for bankruptcy it is possible creditors may still be able to attach claims to the main business for payment if they can prove the business operated essentially as one organization.
There are additional administrative costs to forming a subsidiary, such as legal and accounting fees, to set up another business, and managing multiple tax returns versus just doing everything under your existing business and tax return.
For additional information and resources on the benefits of establishing a subsidiary contact Michael Ceschini of Ceschini CPAs at: (631) 474-9400.