To qualify as a subsidiary under the tax code, the corporation must be part of an affiliated group. An affiliated group is a chain of corporations that own each other’s stock. At the head of the affiliated group is a parent company, and it controls all of the other businesses through stock ownership. All of the businesses in the affiliated group are subsidiaries except the parent. To qualify as an affiliated group, the parent must directly own 80 percent of at least one of the subsidiaries’ voting stock and its stock in general. For other subsidiaries to qualify, 80 percent of the voting stock and general stock of the company in question must be owned by one or more of the other corporations in the affiliated group. Preferred stock is excluded from the 80 percent test. This means that a corporation can issue preferred stock to non-affiliated members and not risk its subsidiary status.
Assume there are four companies: A, B, C and D. All four companies only have common stock. Company A directly owns all of Company B’s stock. Company C’s stock is only owned by Companies A and B. Company D's stock is entirely owned by Companies C and D. In this group, Company A is the parent and Companies B, C and D are subsidiaries.
Consolidate Tax Returns
An affiliated group of corporations can elect to consolidate their tax returns into one return. Consolidated returns offer two major benefits. The first is that the losses of one subsidiary can be used to offset the taxable profits of the affiliated businesses. The second advantage is that any transactions made between the businesses are exempt from taxes. So if one affiliated business sold something to another, the related revenue is exempt from taxes.
Sometimes a business will see fit to spin off a subsidiary or relinquish control over a business so it can act on its own. If a subsidiary is spun off, the parent can distribute the shares of the now-unaffiliated business to the parent’s shareholders. The shareholders do not have to pay taxes on shares they receive from qualified spin-offs. To qualify, the spin-off has to be for a legitimate business purpose other than avoiding taxes. Examples of valid business reasons include cost savings or the parent and subsidiary no longer have similar business purposes. The parent and subsidiary must continue to participate in active business after the spin-off. Finally, the parent’s shareholders must maintain a significant continuing interest in both the parent and the subsidiary after the spin-off.