Dividing Your Company into Several Legal Entities: Safety Rules

The text below is going to be of interest to business owners in those countries where corporate income is taxed at progressive rates. Once your corporate income is low, you pay the tax at the lowest rate. When your income reaches a certain threshold, you are taxed at a higher rate on the outstanding amount. Not all countries apply such a tax system but some of them do.

Now, you may tempted to divide your company into two (three, four, etc.) corporate entities when your income level exceeds the threshold. In this way, each company will be making an income that is taxable at the lowest rate and you will be saving on taxes.

You may think of this maneuver as a tax optimization strategy while the fiscal authorities of your country may think of it as tax evasion. Dividing a company into several companies is not illegal but tax evasion is illegal and the tax agency may take you to court. If you lose the case, you will not only have to pay the tax at a higher rate but you will also have to pay a fine. Thus, eventually, you will end up paying more money instead of saving on taxes. Below we discuss the safety rules that you should follow to avoid such an unpleasant situation.

Safety rule № 1: No hasty company opening

Tax optimization requires careful preparation and risk assessment. The first thing that you have to do is calculate the number of separate companies that you need. This number will naturally depend on the amount of income that you expect to make in the following year. Urgently opening a new company when the income of the existing company is approaching the threshold is not a wise thing to do.

Safety rule № 2: No affiliated legal entities

You will inevitably suspected of tax evasion if the tax inspector sees that several companies paying taxes at the lowest rates have one and the same owner or one and the same CEO. The inspector can often find this information in open sources.

True, this is not illegal to own or head several companies at a time but this may be a cause of suspicion on the part of the tax inspector anyway. Feeling suspicious, the inspector may initiate a thorough tax audit; and dig deep into the connections between the companies owned or managed by one person. You are going to find yourself in hot water if the tax inspector discovers one of the following facts:  

The companies interact tightly with each other on non-market terms. For example, one company makes interest-free loans to the other company or one company sells goods to the other company at prices much lower than the market prices.

The same people work for both (or for all the three, all the four, etc.) companies. It is common practice not to hire new personnel when the company divided into several companies for tax optimization purposes. The same managers sign the documents in both (or in all) companies. More often than not, they are employed on a part-time basis, which indicates that the companies are closely affiliated.

A single accounting department keeps financial records for both (or for all) companies. If only one of your companies has an accounting department while others do not; it is too plain to see that the companies are affiliated. An easy way out would be signing an agreement with an external accounting firm on behalf of each company.

Safety rule № 3. Company division must be justified by business goals and objectives

If you want to divide your company into several companies; you have to be able to justify the division to the tax inspector’s satisfaction. This means that you have to think ahead and plan wisely. For example, the companies in your possession may trade in dissimilar goods. Alternatively, they may sell goods in different geographical regions. Without doubt, there are other opportunities to make the company division justifiable.

Safety rule № 4. Every company has to be independent and self-sufficient

Lack of self-sufficiency is one of the first things that the tax inspector is going to point out if this is the case indeed. This means that you have to take care of the following things.

Every company in your possession has to be an independent business unit; have sufficient fixed assets, costs, a bank account, and subject matter experts on staff. We realize that this may be quite challenging and costly but you might be accused of tax evasion otherwise.

Possible arguments if you are taken to court for tax evasion

Dividing a company into two or more separate business entities is justified when it helps achieve certain economic effects. Having multiple businesses under an LLC, for example, can contribute to increasing the overall revenues, customer base, sales markets, headcount, the value of fixed assets, and so on.  

We have quoted several safety rules to follow when dividing your company into two or more companies; and now let us show you how you can fend off accusations of tax evasion if bad comes to worse and you taken to court. You are going to win the case if you are able to show the following:

1. All the companies are independent business entities, each of them engaged in its own types of business activities.
2. Each company signs contracts with counteragents, bills its customers, and receives payments from them to its own corporate bank account.  
3. Each company files a tax return and pays taxes.
4. Slitting the company into a wholesale and a retail business has helped to optimize the company operations.
5. The main (or the first created) company is not the only supplier of goods or raw materials to the other companies in the group.
6. The companies use different equipment and different production processes and different technologies.  
7. Each company pays for the raw materials out of its own pocket and covers all its production costs by itself.
8. Transfer of employees between the companies is performed through the use of a complete firing-and-hiring circle.
9. The companies use the same trademark on the basis of compensatory license agreements.  
10. A single website for the group of companies is used with the purpose of increasing the amount of sales and decreasing the costs of the website development, promotion, and maintenance.
11. The products/ services produced by one company within the group are dissimilar to the products/ services of other companies.
12. Each company serves a specific group of customers.

Conclusion:

If you follow our advice and divide your company into several legal entities in a wise and forward-looking manner; it can become an efficient instrument of legally decreasing your overall fiscal burden. If you are able to show to the tax authorities that the company division serves the purpose of optimizing business processes, you will thus be able to show that the division does not serve the purpose of evading taxes.