A subsidiary is a separate legal entity owned in whole or in part by another entity. Common forms include limited liability companies, C corporations and even nonprofits. Creating a subsidiary can be more complex than simply maintaining a single organization. It involves incorporating multiple organizations, maintaining separate financial records and even conducting arm's length transactions among entities within a single corporate family. Nonetheless, subsidiaries offer substantial strategic advantages.
Perhaps the most common reason cited for forming a subsidiary is limited liability. Provided that the parent and its subsidiaries respect corporate formalities, it is possible to limit a parent company's potential losses by using subsidiaries as a liability shield. For example, in the movie industry, it is common for each film to be made through its own corporate entity, which can protect the parent company from losses due to lawsuits resulting from a particular production.
A subsidiary provides a legal structure for dividing a business into discrete entities with separate management. For example, in a multinational conglomerate, subsidiaries provide a structural way to adapt to local institutional culture and legal requirements. It can also be a means of accommodating different incentive structures, such as linking executive pay to the economic performance of a particular company or using both for-profit and nonprofit subsidiaries within a tax-exempt university or hospital.
Identity and Branding
A subsidiary provides a structural framework for diversifying corporate identity. Within a conglomerate it is possible to maintain the integrity of discrete brand identities through separate subsidiary enterprises, such as the way The Gap, Inc. uses Gap, Old Navy, Banana Republic and Piperlime to target different segments of the fashion market.
As Randy Myers notes in his Journal of Accountancy article, "Is a Subsidiary in Your Future?", tax considerations can play a major role in the decision to form a subsidiary. For example, Myers explains, a company can benefit from using subsidiaries in a state such as Pennsylvania or Michigan, where a subsidiary is taxed only on in-state profits rather than on all of the profits generated by the company nationwide. Likewise, an international business can form a foreign subsidiary to take advantage of lower tax rates in another country. Creating a subsidiary is also useful for nonprofit organizations, which use subsidiaries to preserve their tax exemption by separating unrelated business activity from for-profit commercial ventures.
Structured properly, a subsidiary can be used to attract additional investors, reduce regulatory requirements for certain transactions, facilitate tax-free mergers or sell a line of business. As a result, using a subsidiary to spin off a particular venture can be an effective and profitable way to maximize shareholder value.