In essence, a holding company is formed to control something. Often that means it holds the control of assets that may be utilized by a subsidiary company of the holding company. The subsidiary operates the assets as part of its business and is referred to as the operating entity. The assets, which could include land, buildings, technology, intellectual property or equipment, are most often leased to the operating entity, and the holding company retains ownership of the assets at all times.
Why does this structure exist?
The central purpose of a holding company-operating entity structure is to limit risk. If an operating entity does not own any of the valuable assets it uses in its business, those assets are not available to the operating entity’s creditors in the case of lawsuits, bankruptcy or other difficult financial circumstances. There may also be tax benefits to such a structure. Taxation is certainly a major consideration when establishing a holding company and assigning assets to that company but the focus of this article is on limiting liability.
Doesn’t a corporation or limited liability company already provide limited liability?
A limited liability company (LLC) and corporation already limit the liability of the business owner. Assuming the LLC or corporation is properly established and operating in accordance with state law, the personal assets of the business owner are protected from claims made against the business. However, although operating your business as an LLC or a corporation protects your personal assets from claims made by business creditors, the assets of the business itself remain at risk to such claims.
Adding the layer of a holding company structure protects the business assets from both business and personal creditors. The operating entity has possession and use of the assets, but it does not own the assets. Its rights in the assets are via a lease (or other similar arrangement) with the holding company, which actually owns the assets. A holding company has virtually no risk of claims being brought against it by creditors because it has no business relationships other than the lease agreements it maintains with its subsidiary operating entities.
The operating entity conducts all of the combined business’ affairs and its relationships with third-party suppliers, customers and others. It sells and ships goods and/or provides services to customers or otherwise conducts all of the revenue-generating business activity. Therefore, it bears all the risk of loss inherent in the combined business. The holding company is not responsible for the debts of the operating entity. If the operating entity should need to close because of financial problems or creditor lawsuits, the holding company would simply repossess the assets and redeploy them with another subsidiary or liquidate them for cash.
Entity Structure and Ownership
Depending on the business and the individuals involved, the holding company could form the operating entity and own that entity in its entirety. In that case, the individual owners would own the holding company and the holding company would own the operating entity. In this structure, the operating entity is a subsidiary of the holding company. Alternatively, the individual owners could own both entities. The end result, in terms of shielding the assets from creditor claims, is the same.
Removal of Cash
A key benefit to the holding company structure is the ability to remove cash (by means of lease or royalty payments) from the operating entity. Coupled with the fact that the operating entity owns little or no valuable assets, this further limits the exposure of the operating entity to creditor claims. An alternative (or supplement) to leasing assets is for the holding company to loan funds to the operating entity. The operating entity would use those funds to acquire the assets it needs to operate its business. The holding company would retain a first priority lien on the acquired assets. The result would be essentially the same in terms of the transfer of cash and the minimization of risk.
The Corporate Veil
It is vital that all the entities involved in this structure, the holding company and each subsidiary or affiliated operating entity, are operated separately and independently. In addition to keeping its own books and records, each entity must govern its own affairs by observing all required corporate formalities. The reason for this is to avoid any piercing of the “corporate veil.” The corporate veil is what provides LLCs and corporations with limited liability and it may be pierced if a claim can be successfully made that there is no difference, no separation, between the owners of the LLC or corporation and the entity itself, that they are effectively one and the same. While a detailed discussion of the corporate veil and its piercing are beyond the scope of this article, it is an important consideration when forming and operating a holding company structure as discussed in this article.
Conclusion
The holding company strategy is a well-established means of minimizing business risk and can be utilized by enterprises large and small. This article just touches on the very basic elements of establishing and operating such a business structure. There are alternatives to this structure that should be considered when determining what’s the best structure for your particular business. You should consult an attorney with experience in these matters before deciding if a holding company structure is right for your business.
If you have any questions regarding these matters or need related legal assistance, please contact me.
