Complex ownership structures are a key feature of the world’s most financially sophisticated businesses. The biggest players may control hundreds or even thousands of legal entities, each dedicated to specific parts of the broader business. They structure their businesses this way to accomplish certain goals: isolating risk behind limited-liability entities, segregating investor groups, optimizing tax performance, and so on. 

At the relatively modest scale of most construction businesses, choosing the right legal structure still matters. Although this is a topic for corporate attorneys and tax advisors, financial professionals should develop a working knowledge of how legal structures can work for us.

Choosing the right legal form

Every construction business should be operated under a limited liability entity to protect its owners from personal financial responsibility for the business’s losses. The choice of a specific entity type—typically, between a limited liability company, a C-corp or S-corp, or a partnership—comes down to these considerations:

• What is the relationship of the owners to each other and to the business? A corporation’s shareholders don’t have direct control of the business, which is run by its board of directors. An LLC’s members, on the other hand, can exercise direct control. 
• How is the company taxed? The pass-through taxation available to the owner of an LLC or S-corporation can significantly reduce the impact of taxes on cash distributions from the business. As the business grows, tax considerations can spark a change of legal form.
• How is the business financed? A business that raises capital from investors will face dramatically different structural requirements from one operated on credit.
• What are the business’s risks? To take full advantage of limited liability, a business needs to take stock of what its liabilities really are. A business needs to be structured and capitalized to suit its anticipated exposures.

When to form a subsidiary?

Regardless of the form taken by the business’s parent entity, forming subsidiaries can be a good idea in many situations. 

The main reason to form a subsidiary is to manage risk. Limited liability isn’t only for a company’s human owners. It extends to corporate owners as well. A parent organization can shield its assets from a high-risk situation by housing the risk within a stand-alone entity. Here are some examples:

• Specific projects. A project-specific LLC can, for example, shield the parent from liability under contracts with subcontractors or the client.
• Employment. A separate entity can be formed to be the legal employer of some or all of the company’s staff.
• Equipment. Placing a business’s equipment ownership and leasing into a separate entity can simplify financial management and allow for greater flexibility.
• Joint ventures. Partnering with other businesses using stand-alone legal entities provides a ready-made framework for managing capital flows, oversight authority, and risk. 

Some businesses use a fee-based model to turn subsidiaries into sources of revenue. For example, an equipment subsidiary could charge its parent fees to use equipment, while the parent charges its subsidiary a fee to manage its operations. Although these arrangements are complex to set up, they can internalize and therefore control expenses for revenue and tax purposes.

Know the downsides

Operating a subsidiary comes at a price. Lawyers need to be involved not only to organize the legal entity but also to document the relationship of the parent to its sub. Depending on its operations, the sub may need its own insurance policies. The accounting and tax teams will need to spend extra time to properly maintain the subsidiary’s books. 

Subsidiaries also can raise complex financial questions for their parents. Some counterparties, like banks, may refuse to do business with a subsidiary that lacks a credit history unless the parent guarantees the subsidiary’s debts. The history of corporate collapses is littered with examples of parent organizations making too many promises on behalf of their subsidiaries, and discovering too late that they had accumulated debts they couldn’t pay.

Ask your colleagues at the CFMA

As financial professionals, we are often at the mercy of tax planners and attorneys who drive the major decisions about how a business is structured. Nevertheless, we need to understand how their planning affects our work. Those of us working in smaller businesses that don’t have corporate lawyers on speed dial might have an opportunity to suggest a new strategy.

How has your business leveraged the possibilities of sophisticated legal structures? We encourage you to join the conversation with your colleagues at the CFMA on our membership forum, on LinkedIn, or at the next chapter meeting.