NOTE: This article was written under contract for a client. It is not for publication
How to Handle Holding Company Taxes
The holding company form of doing business is often utilized when an integrated business is engaged in related but distinct operations. They involve special tax considerations.
What is an affiliated group?
Businesses often conduct separate but related operations. The separate operations might be affiliated vertically (e.g. links in the supply chain for a single product) or horizontally (e.g. production and sale of different products).
A business might operate these separate functions as divisions of a single organization or as separate but affiliated entities.
Corporations
The corporation form of doing business offers stakeholders the advantages of privacy and limited liability. Their business is operated in the name of the company without identifying the owners. The owners are not liable for the company’s debts and obligations.
Corporations are business organizations organized under state law. They are legal entities existing separately and apart from their owners.
On the disadvantage side, as separate entities, corporation earnings are subject to taxation before they are distributed to shareholders where they are taxed again.
Why do businesses use holding company business structures?
A major reason, for operating a business with separate but related functions as separate but related corporations, is to insulate each function from the liabilities of the other functions.
Corporations are affiliated if they are controlled by a common owner or owners. The simplest affiliation is a parent company that owns all or controlling interest in a subsidiary company. Two or more corporations are affiliated as brother-sister corporations if they each are wholly owned or controlled by a common parent corporation.
The common parent, the holding company, usually has as its only function the ownership and control of its subsidiaries.
It should be noted, however, that to assure insulation from an affiliate’s liabilities, each corporation in the affiliated group must have real substance in terms of capitalization, activity, or both.
State law considerations
Operating a business as an affiliated group of corporations can have state law and tax advantages. For example, some states, including Wyoming, have no income tax. A resident of Illinois, which has among the highest state taxation, could allocate some of their business income to a Wyoming nexus.
That would require organizing a corporation in Wyoming to conduct a substantial portion of the business to which a sizable portion of the business income could be allocated.
Consolidated returns
While there are non-tax advantages of operating through separate affiliated corporations, ordinarily each entity would be required to file separate tax returns. Also, in some cases, intercompany transactions might be subject to tax that would not apply if the operations were conducted as divisions of a single corporation.
The federal income tax law recognizes the economic substance of an affiliated group as compared to the legal formalities of state corporation law. Accordingly, some affiliated groups have the option to file one consolidated return. Essentially, a consolidated return allows the members of an affiliated group to report all of their transactions as if they were divisions of a single entity.
Limited liability companies
An affiliated group is not limited to C-corporations, the oft-used name for state law corporations because they are taxable under the provisions of 26 U.S. Code Subchapter C.
A limited liability company (LLC) is an entity formed under a state law that every state now has. Subject to several requirements and limitations, an LLC can elect to be taxed or to be treated as a non-taxable pass-through organization such as a partnership.
An LLC may be a member of an affiliated group and joined in a consolidated return reporting of inter-company transactions