Table of Contents
A shell company is a legal entity that has no significant business assets or operations. It can be used for a variety of purposes, both illegal and legitimate: from hiding certain activities from law enforcement to providing a legal structure that can be used to take a company public.
A shell company can be set up by a large corporation or a private individual. Legitimate uses of a shell company include setting up a foreign entity for a domestic operation in order to manage tax liabilities, or even to facilitate mergers or acquisitions. Another common use of a shell company is to set up a special purpose acquisition company, or SPAC.
Because shell companies can occupy certain gray areas, it’s important for investors to do their research to avoid fraudulent entities.
Key Points
• Shell companies are legal entities without significant assets or operations, often used for raising funds, tax benefits, and protecting assets.
• Shell companies have legitimate uses, but could be used to shield illegal activities from the law.
• Legitimate purposes include facilitating public listings, holding assets, or managing tax liabilities.
• Establishing a shell company involves registering through an agent, setting up accounts, and managing operations, despite lacking substantial assets.
• Investors must conduct thorough due diligence to avoid fraudulent shell companies, ensuring understanding and verifying legitimacy.
How Are Shell Companies Created?
There is more than one way to create a shell company. Most often, the people or corporations that launch new shell corporations use a registered agent in the country where the company will have its legal headquarters. So, in the United States, shell companies would need to register with the Securities and Exchange Commission (SEC).
In most countries, the agent must register his or her name, and the name of an owner or a shareholder director. The cost of creating and legally registering a corporation will vary from country to country, from as little as a few thousand dollars to as much as several hundred thousand dollars.
Being “hollow,” by definition, shell companies can do many things. They can open bank and brokerage accounts. They can transfer funds in and out of their home country. They can buy and sell real estate or other companies. They may own copyrights and earn royalties on those copyrights.
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3 Uses of Shell Companies
People and corporations use shell companies in a wide range of legitimate businesses for legitimate reasons. Those might be used as a vehicle to raise funds, as a legal entity to attempt to take over another business via a reverse merger, or as a legal entity to give form to a company that intends to go public.
1. Tax Benefits of Shell Companies
Many shell corporations operate in a legal gray area, and it’s possible that corporations and wealthy individuals may use them to avoid taxes.
Many companies have found ways to move their profits to offshore shell corporations to take advantage of less expensive, or more permissive tax rules in other countries (similar to how some states may be more tax-friendly than others). American corporations might set up shell companies in countries with inexpensive labor, where they have already begun to outsource some of their operations.
Corporations aren’t the only ones that use shell companies to avoid paying taxes. Wealthy individuals around the world may also use shell corporations, domiciled all over the world, to hide their earnings and their wealth.
2. Less Risk, More Opportunity
Tax avoidance isn’t the only reason a corporation would set up a shell corporation. It might create a shell company to operate in a country, while protecting its other operations from the legal, political, and financial risks related to that country. That way, if something goes wrong in the country where it operates, the parent company can limit its exposure by existing — at least on paper — offshore.
A corporation may also set up a shell corporation in another country to gain a window into new regions. A business might set up a shell company in Panama or Switzerland to gain access to the local business community, in order to generate contacts and information that would lead it to business opportunities in Latin America or Western Europe.
3. SPACs
While shell companies come up in the news in relation to questionable tax-avoidance schemes, in recent years, they’ve also been mentioned alongside special purpose acquisition companies, or SPACs.
At any given time, there may be hundreds of shell companies that qualify as SPACs — which may be a reason that SPACS were so popular for a couple of years in 2020 and 2021. These are companies formed exclusively to raise capital via an initial public offering (IPO), which will then purchase a private company already in operation. SPACs are a type of “blank check company.”
These companies issue an IPO, then hold the money in a trust, until the SPAC management team chooses a company and buys it — thereby taking it public. And if the SPAC doesn’t find a company to buy, or can’t buy the company or companies it likes within a pre-set deadline — often two years — then the managers promise to liquidate the SPAC and give investors their money back.
How Shell Companies Operate
Shell companies operate as a sort of holding entity, since they generally don’t have any business operations. So, they’re structures that exist as a containment entity more so than an actual company.
Common Characteristics of Shell Companies
As noted, shell companies have some common characteristics, though they may not exist in each and every instance:
• No business activity or revenue
• Lack of or few assets
• Few, if any, staff members
• Management is located in another country
Again, there are many forms that shell companies may take, and they may not all share the same characteristics.
Differences Between Shell Companies and Traditional Businesses
Perhaps the biggest and most obvious difference between shell companies and traditional businesses is that shell companies don’t usually have any sort of business operations. That is, they’re legal entities that aren’t designed to necessarily drive revenue and produce goods or services.
Conversely, a traditional business has assets, managers, employees, and produces goods or services with the goal of generating revenue and profits for its owners. And while a traditional business may in fact own other businesses, it does so, again, with the goal of generating profits. In short: Shell companies tend to exist for different reasons than traditional businesses.
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Example Shell Companies
An example of a shell company could be as follows.
Say there’s an entrepreneur that’s looking to raise money before they officially launch a startup. They may create an LLC, which is a business entity, that doesn’t have any assets or employees. It only exists on paper. But the business entity — a shell company — can be used to hold the money being raised for the startup prior to its launch.
In effect, the company itself is merely a shell used to hold cash until it’s ready for use. It’s not really a functional business in the traditional sense.
Shell Companies and Shady Dealings
While there are many legitimate uses for shell companies, as outlined, bad actors also might use them to shield their operations and their assets from authorities. And as different jurisdictions compete for business, new loopholes emerge on a regular basis. In Panama, the British Virgin Islands, and in certain states, there are strong laws that prevent the government from revealing the beneficial owner of a given shell corporation.
And for creative financiers, there are always new ways to add layers of anonymity, such as phony company directors, who agree to sign their names for a few dollars. Among professionals who specialize in such things, there are ways to find would-be board members, and for countries and states with convenient tax and privacy laws.
Are Shell Companies Legal?
Yes, shell companies are legal, and are most often used for legal purposes. While they can be used for illegal purposes, many shell companies have legitimate purposes.
Shell Companies vs Holding Companies
Though there may be some superficial similarities, shell companies and holding companies are not the same thing. As discussed, shell companies may be formed to serve as empty entities that may be used to take advantage of different taxation regulations, for example.
A holding company, on the other hand, is like a parent company. Holding companies hold or own other companies within it, like an umbrella. It allows its owners to control numerous businesses without necessarily actively managing any of them.
Spotting Red Flags as an Investor
For investors worried about getting their money tied up in a potentially shady shell company, there are some things to keep an eye out for, and steps to take before making any sort of investment.
How to Identify Risky Shell Companies
When it comes to looking out for shell companies that may pose risks to your portfolio, you may want to research where a company’s communications are coming from (are they written by an actual person, or an anonymous author?), the company’s history (does it actually have a history of business operations and revenues?), where its stock trades (is it an over-the-counter (OTC) stock, or does it trade on a large exchange?), and more.
Warning Signs of Fraudulent or Illegitimate Shell Companies
Specific warning signs that a shell company may be fraudulent or illegitimate may include:
• Trading outside major exchanges: As noted, an OTC stock may require some more due diligence for investors.
• Changing business names: If the company has a history of shifting its focus or name, that could be a red flag.
• Look for “Q”: Stock ticker symbols that end with a “Q” sometimes indicate that the company has filed for bankruptcy. That could be a warning sign for investors.
Due Diligence Steps Before Investing
In addition to looking out for some of the potential warning signs outlined, investors can do some extra due diligence and research into a company’s directorship and management, to see where it’s based, and who comprises it.
Further, “mass registrations” to a single address could also be something to look into. If there are hundreds or thousands of companies registered in a single place, that may be a worrisome sign. Additionally, dig through some of the company’s quarterly and annual reports to look for financial anomalies. That could, again, reveal some troublesome patterns that investors should take into account.
Risks of Investing in Shell Companies
Investors should know the risks of investing in shell companies.
Potential Financial and Legal Consequences
As discussed, shell companies are legal, and many are used for perfectly legitimate purposes. But if they’re being used for nefarious reasons, such as money laundering or other criminal purposes, there could be consequences that could affect investors.
While the risk of losing your investment is always an issue, it’s also not out of the realm of possibility that if a shell company is caught up in a legal melee, that the investors themselves could end up facing financial penalties and fines, or even legal consequences. That, however, depends on the specific circumstances of each entity.
Regulatory Scrutiny and Compliance Issues
In recent decades, regulators have become increasingly aware of the use of shell companies to potentially cover up criminal actions, so there’s been more interest in scrutinizing them and making sure they’re complying with applicable laws. That could lead to legal problems, or not. It depends on the specifics.
How to Protect Yourself From Investment Scams
For investors, protecting yourself from an investment scam or a shady shell company comes back to the basics: Do your due diligence, and perhaps steer clear of any investment that presents red flags.
That includes looking through company reports and filings, doing your best to track down the company’s management and directors, looking for anything fishy in terms of name-changes or wild revenue swings, and more.
Regulations and Oversight of Shell Companies
Like any other type of business or company, shell companies are subject to regulation and oversight.
Global Efforts to Curb Illicit Use
As mentioned, shell companies have become known for their use as money laundering vehicles, or to help facilitate other types of crimes. The Panama Papers in 2016, and the Danske Bank scandal that unraveled in 2018, are two instances in which the world learned a lot about how shell companies can be used illicitly.
Accordingly, many companies cooperate across jurisdictions to exchange information and try to curb illicit use. There may be specific laws in different countries, and the U.S. has its own as well.
Compliance Requirements for Legitimate Shell Companies
In the U.S. shell companies are required to report ownership information to the Financial Crimes Enforcement Network, or FinCEN, as part of the Corporate Transparency Act, which became law in 2021. That law attempts to shine a light on who, exactly, owns these companies, and could be benefiting from illicit use. However, that law may not be enforced per new Trump administration guidelines.
Further, there are anti-money laundering rules and Know Your Customer (KYC) procedures in the mix, often depending on specific companies (like banks) that can help regulators do due diligence and flag suspicious activity.
The Takeaway
Shell companies are legal business entities that are often used for legal reasons, such as managing tax liabilities or raising funds. Shell companies can be used for illegal purposes, too — e.g., money laundering — which is what they’re often associated with.
Most investors wouldn’t invest in shell companies in their day-to-day trading, but they might consider allocating part of their portfolios to a SPAC. It’s important to remember that these are speculative, risky investments, so they don’t make sense for every investor.
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FAQ
Is a shell company legal?
Yes, shell companies are legal, and are generally used for legal purposes. A shell company is simply a business entity that has little to no assets or employers, and doesn’t engage in standard business operations. However, investing in shell companies is risky due to the lack of transparency, increased vulnerability to manipulation, potential for fraudulent activities, and regulatory and legal risks.
What is an example of a shell company?
An example of a shell company could be an LLC formed by an entrepreneur planning to launch a startup. The entrepreneur files the paperwork to create the LLC, and then uses it to gather funds until the startup launches, rather than have the LLC engage in any business itself.
What is the difference between a holding company and a shell company?
Holding companies are parent companies, or umbrella organizations, that often have multiple businesses running underneath or within them. Shell companies typically do not have assets or employees, or any meaningful business operations.
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