Recently, on the local public radio, there was a story about renowned English rock band Radiohead. Moving away from the very common theme of popular artists and their financial struggles, drug addictions, legal problems, or tragic deaths, this segment discussed Radiohead and their business empire. Early on, Radiohead started the practice of forming a separate legal entity for each record they released. Each entity would then hold all of the income earned from that record (including income from concerts) and contain within it all risks associated with that record (including any motor accidents during a tour). Over the years, Radiohead has formed an empire of over 20 companies (including one interestingly named Random Rubbish, Ltd). That’s good business practice mixed with some humor.
Many businesses are run completely out of only one legal entity and that is perfectly reasonable. However, sometimes, it is important to consider creating affiliates or subsidiary companies (and sub-subsidiary companies) to limit business risks. For example, if you, as a business owner, also own the real property out of which your business is operated, you may want to consider separating and moving the business property in an entity different from the one running the business operations. You can run the business operations out of an “S” corporation (S-Corp), which has its own tax benefits, and the business property can be held in a limited liability company (LLC) and rented to the S-Corp. Now, if your business is liable for any damages arising out of its operations (bad debts, employment litigation, etc.), there is a good fighting chance of preventing creditors or other people holding judgments against the S-Corp from reaching the LLC property.
Taking it a step further: now, if a business has multiple business lines (bicycles and biking shoes), divisions (retail and wholesale operations), or multiple locations for the same type of business, the S-Corp can have its own subsidiaries and sub-subsidiaries. Alternatively, the business owner can create multiple affiliate S-Corps to own and operate each business line, division, or location, and, for convenience and efficiency, each of the S-Corps and LLCs can themselves be owned by a separate, parent holding company. Under this scenario, you, as the business owner, will only hold ownership interest in the holding company. And, for tax purposes, often the subsidiaries can be treated as just one company even though they are treated as separate companies for liability shield purposes.
Creating affiliates or subsidiary companies this way with different entities is like having an extra insurance policy without any of the restrictions and limits generally associated with insurance. But one overarching rule to ensure the benefits of the liability shield, in addition to the proper formation of the affiliates or subsidiary companies, is to treat each of entities as separate and distinct entities. When business owners fail to do so, then the design fails and the business’ creditors, likewise, need not treat the entities as separate and can “pierce the corporate veil.” To keep the entities separate and distinct, the entities should at the very least have different bank accounts and there should be no commingling of funds (for example, a business owner should not pay the utility bill of one company out of the other company’s bank account). Additionally, the entities should have different letterhead, billing invoices, and business cards. Ideally, each entity should also have different telephone numbers, locations, and employees. While it may not always be feasible, every effort should be made to make these separate and easily verifiable. For example, if the entities share personnel, then business owners should ensure that each company pays its fair share for the use of those personnel.
There is, however, one caveat to remember when creating subsidiaries. The liability shield only protects liabilities from traveling upstream but not downstream. For example, if a creditor gets a judgment against a subsidiary S-Corp, without the court piercing the corporate veil, the creditor cannot make collection efforts against the parent company. If, on the other hand, the creditor gets a judgment against the parent company, the separate, distinct status of the subsidiary will not protect the subsidiary’s assets against this creditor. The subsidiaries assets are just like any other asset of the parent and will be subject to the judgment. For that reason, we prefer that the parent be a holding company and not engage in business itself.
Properly forming and maintaining business entities’ ownership structure for liability protection purposes can be complex and you must consider the tax consequences of any such decision. For more information on this topic, please contact Sherap Tharchen at 303.376.6024 or by email at firstname.lastname@example.org.