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Three Instances of When You Need a New Subsidiary Entity for Your Business

Photo of an empty, minimalist boardroom overlooking an empty field.Are you growing your business? Adding new products or services? New locations? Adding partners or owners? If so, these are all instances when you should consider setting up a subsidiary or other new entity for your existing company. While you can run multiple streams of business through one entity, there are tax, asset protection, and partnership reasons why you may want to open up a new subsidiary entity for your new activity.

Let’s run through a few common situations when it makes sense to open up a subsidiary entity. And by subsidiary, I mean “a new entity which is owned wholly or partly by your primary business entity or by a common holding company.” Your new subsidiary could result in a parent and child relationship where your primary entity (parent) owns the new subsidiary entity (child), or it could be a brother and sister type structure where the primary business is a separate entity (brother) to the new entity (sister) and the two are only connected by you or your holding company that owns each separately and distinctly. (See the diagrams below to view the differences.)

I. Adding a New Product or Service

You may want a new entity to separate and differentiate services or products for liability purposes. For example, let’s say you are a real estate broker providing services of buying and selling properties and you decide to start providing property management services. Because the property management service entails more liability risk, a new entity owned wholly by your existing business could be utilized. The benefit of the new subsidiary is that if anything occurs in the new property management business, then that liability is contained in the new subsidiary and does not go down and affect your existing purchase and sale business. On the other hand, if you ran the property management services directly from the existing company without a new subsidiary and a liability arose, then your purchase and sale business that is running through the same entity would be effected and subject to the liability.

For tax purposes, in this instance, the income from the new subsidiary entity (child) will flow down to the parent entity without a federal tax return, and as a result, there is no benefit or disadvantage from a tax planning standpoint.

 

Diagram displaying the Parent-Child Subsidiary structure

 

II. Opening a New Location

What if you’re establishing a new retail or office location for your business? Let’s say you are a restaurant opening up your second location. For asset protection purposes, you should consider setting up a second entity for the new location. This can limit your risk on the lease (don’t sign a personal guarantee) for the new location or for any liability that may occur at the new location. In this instance, if one location fails or has liability, it won’t affect the other location as they are held in separate entities. The saying goes, “don’t put all your eggs in one basket.” In this case, the basket is the same entity and the locations are your eggs.  In the multiple location scenario, you should consider the brother-sister subsidiary structure such that each location is owned in a brother-sister relationship (e.g. neither owns the other) and their common connection is simply the underlying company (or person) who owns each entity for each location. Because both locations have risk it is useful for each to have their own entity and not to own each other (as can occur in the parent-child subsidiary). When structured in a brother-sister relationship, the liability for each location is contained in each subsidiary entity and cannot run over into the other subsidiary entity (the sibling entity) or down to the owner (which may be you personally or your operational holding company).

For tax purposes, the brother and sister subsidiary income (usually single member LLCs) flows down to the parent or primary entity where a tax return is filed (usually an S-Corp). (See the diagram below for an illustration.)Diagram displaying the Brother-Sister Subsidiary structure

III. Adding a New Partner

Maybe you’re starting a new business or operation where you have a new partner involved. If this partner isn’t involved in your other business activities or your existing company, it is critical that a new entity be established to operate the new partnership business. If you have an existing entity where you run business operational income (e.g., an S-Corporation), then this entity may own your share of the new partnership entity (e.g., an LLC) with your new partner. Your share of the new partnership income flows through the partnership to your existing business entity where you will recognize the income and pay yourself. In this instance, your existing entity is the parent and the new partnership is a partial-child subsidiary. The new partnership entity will typically file a partnership tax return.

IV. California Caveat

Because of gross receipts taxes in California, you may use a Q-Sub entity model where the subsidiary entity is actually another S-Corporation and is called a Q-Sub. This is available only when the parent entity is an S-Corporation and can avoid double gross receipts tax at the subsidiary and parent entity level.

Make sure you speak to your tax attorney for specific planning considerations as there are asset protection and tax considerations unique to each business and subsidiary structure.

Solo K 5500-EZ Requirement and $15,000 Failure to File Relief

Up close photo of an egg-shaped egg timer.Do you have a Solo 401(k)? Have you been filing form 5500-EZ each year for the Solo 401(k)? Are you aware that there is a penalty up to $15,000 per year for failure to file? While some Solo 401(k)s are exempt from the 5500-EZ filing requirement, we have ran across many Solo 401(k) owners who should have filed, but have failed to do so.

The return a Solo 401(k) files is called a 5500-EZ, and it is due annually on July 31st for the prior year. If you have a Solo 401(k) and you have no idea what I’m talking about, stay calm, but read on.

Benefits of Solo 401(k)s

One of the benefits of a Solo 401(k) is the ease of administration and control, because you can be the 401(k) trustee and administrator. However, as the 401(k) administrator and trustee, it is your own responsibility to make the appropriate tax filings. This would include filing any required tax returns for the 401(k).  Solo 401(k)s with less than $250,000 in assets are exempt and do not need to file a 5500-EZ. All plans with assets valued at $250,000 or greater must file a form 5500-EZ annually. A tax return is also required for a Solo 401(k) when the plan is terminated, even if the plan assets are below $250,000. Recently, more and more Solo 401(k) owners have contacted us because they set up their Solo 401(k) online or with some other company, and were never made aware that they are supposed to file a 5500-EZ when their plan assets exceed $250,000.  Some of these individuals have multiple years in which they should have filed the 5500-EZ, but failed to do so. The penalties for failing to file a 5500-EZ when it is required can be quite severe, with fees and penalties as high as $15,000 for each late return plus interest.

Failure to File Relief

Fortunately, the IRS has a temporary pilot program that provides automatic relief from IRS Late filing penalties on past due 5500-EZ filings.  The penalty relief began as a temporary program in 2014 and was made permanent via Rev Proc 2015-32.

In order to qualify for this program, your Solo 401(k) plan must not have received a CP 283 Notice for any past due 5500-EZ filings, and the only participants of your Solo 401(k) plan can be you and your spouse, and your business partner(s) and their spouse. There is a $500 fee due for each delinquent return up to a total of $1,500 or three years.  This program is available to all Solo 401(k) plans, regardless of whether it is a self-directed plan.

The IRS has provided details via Rev Proc 15-32. In order to qualify and receive a waiver of penalties under the program, you must follow the program exactly.  In short, you must do all of the following:

  1. File all delinquent returns using the IRS form in the year the filing was due. This must be via paper form.
  2. Mark on the top margin of the first page, “Delinquent Return Submitted under Rev. Proc. 2015-32.”
  3. Complete and include IRS Form 14704.
  4. Mail all documents to the IRS, Ogden, UT office.

In sum, if you have a Solo 401(k) plan that should have filed a 5500-EZ for prior years, then you should take advantage of this program, which will save you thousands of dollars in penalties and fees.  If you have any questions about this program or would like assistance with submitting your late 5500-EZ filings under this program, please contact our law firm as we are assisting clients with current and past due 5500-EZ filings for their Solo 401(k)s.