When one company takes a significant ownership interest in another through the purchase of stock, it also takes on substantial power to influence the subsidiary's dividend policies. The tax code, however, restricts the ability of the parent company to defer income tax liability by influencing the subsidiary company to avoid paying dividends.
Equity Method vs. Cost Method
There are two basic methods of accounting for the earnings of a company in which another company has purchased stock: the cost method and the equity method. Under the cost method, the parent company does not have to report earnings from the stock in its portfolio unless it actually receives a dividend. Under the equity method, the parent company must declare a prorated portion of the reported earnings of the junior company on its own books, even if it doesn't receive a dividend.
Taxation Under the Equity Method
Corporations cannot own S corporation stock. Therefore, all corporations owned by other corporations must be C corporations. C corporations must pay income tax on earnings prior to paying a dividend. However, earnings are reported after tax. When a corporation owned by another corporation declares earnings using the equity method, the parent company adds the earnings per share, multiplied by the number of shares in its portfolio, to its own revenues, where they are subject to income tax of up to 35 percent, unless the business has offsetting deductions.
When You Must Use the Equity Method
Generally, you have the option of using the cost method if your company owns less than 20 percent of the subsidiary. This is because with a small stake, the IRS does not consider it likely that the parent company will exercise undue influence over the other company. If you hold a larger stake, however, you must generally use the equity method of accounting for the profits in the company in which you own stock, without regard for its dividend schedule.
Capital Expense Accounting
When a company buys stock in another company, it establishes a tax basis equal to the cost of acquiring the shares. The shares themselves are listed as an asset on the balance sheet at their current fair market value, and the balance sheet is frequently updated to account for changes in the value of these shares. When the company sells the stock, capital gains taxes apply on any profits from the sale, over and above the earnings reported by the owned company.