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Succession Resource Group is a boutique succession consulting firm based in the Pacific Northwest, serving clients across the country. SRG was founded by David Grau Jr., MBA in 2012 after nearly a decade of helping advisors with valuation and succession planning. SRG's team of experts leverage their industry expertise, combined with best-in-class resources, to help advisors, agents, and accountants manage the equity in their businesses...

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12 min read

Set Your Firm Up for Success — Using Entity Structure to Unleash Growth

Nov 27, 2023 6:53:59 PM

Starting your business as a financial advisor is an exciting prospect. You're setting the foundation for a successful future and commitment to growth. Whether you are creating a platform to last the duration of your career or working to formalize/upgrade your established enterprise, effective entity planning and setup will serve as the base on which you can build and hopefully as a springboard for future generations.

But there are important considerations to navigate when setting up an entity that are almost always overlooked and go beyond using your state’s website or an online filing service to establish an entity. 

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Financial advisors have unique considerations and constraints when it comes to forming business entities, which are even more important to get right as you grow and scale your business. Here are the areas that you need to examine when choosing an entity type. 

Getting the Basics of Entity Right 

Why Financial Advisors Set Up a Legal Business Entity

Business goals play a major role in choosing the ideal structure for an entity. Short-term needs and long-term goals are important to consider, but there are also highly specific reasons unique to financial advisors for choosing an entity. 

Entity Structure as a Personal Liability Shield 

Protecting yourself and your personal assets from business risks is paramount. Your E&O insurance is great but won’t address your other liabilities as a business owner.

Personal liability protection becomes a concern when your firm grows, you hire/fire, sign contracts, retain outside experts, and you take on larger amounts of more complex engagements. If you have business partners, you could potentially be held liable for their actions. Creating an entity is a simple and effective way to ensure that liabilities stay with your firm, not you as an individual. 

Equity Sharing Enables Firm Growth

When you grow your financial advisory firm, equity sharing is another factor to consider. More firms attract and retain quality talent by structuring incentive programs that leverage the value and equity in the business.

Equity sharing can be an effective way to fulfill promises of advancement to rising stars as part of your firm’s career path. It can also be used to add new business partners and merge with other advisors as your firm grows and evolves. Having an entity and the related governance agreements in place gives you something that is easily divisible and helps ensure you can get the equity back should you need to.

When operating as a sole proprietor, equity sharing is effectively impossible since a sole proprietor consists of only one professional, and adding a second then creates a defacto partnership with no liability protection or tax savings, which isn’t the intended outcome for most advisors adding a partner or junior partner. 

Tax Advantages of Proper Setup

Setting up an entity will not guarantee you’ll save money on taxes, but when done right, most advisors do have tax savings – which, as you grow, becomes more and more material. But beyond the typical tax savings (again, when done right), you will find major tax savings as you leverage the entity to buy practices, sell equity internally, or merge outside practices in.  

Extended reading: First DOL, Now IRS Gunning for Advisors

Advisory Firm Entity Structures and Taxation

Understanding the Difference Between Legal Form and Tax Status 

When setting up an entity, there are two different aspects to keep in mind that can be confusing: the basic legal form and the tax status.

The legal structure is registered with your state, such as a limited liability company (LLC) or corporation. This legal form determines which laws in that state apply to the entity. This may mean that there are statutes regarding how that entity can be managed and operated, and business formalities that must be followed. 

The tax status pertains to how tax authorities like the IRS view your entity. For instance, you’ll notice on the tax forms that there is no box to check for an LLC, because an LLC is only a legal form, not a tax status. In the example of an LLC, you must then choose how the LLC will be taxed. A single-member LLC, for example, is usually taxed as a sole proprietorship (a disregarded entity) where the income and deductions are reported on your personal tax return. Multiple-member LLCs are usually taxed as partnerships, unless you elect to have your LLC taxed as an S-corporation (but it's still an LLC in the legal sense).

If you form a corporation, the IRS needs to make a distinction whether it's a C or S corporation, because it makes a dramatic difference tax-wise. There are also nuances to consider, such as who will/can own an interest in your LLC or S-Corp, and understanding the pros and cons of each entity type as it pertains to the legal and tax implications. 

Pass-Through Taxation for Financial Advisors

To further elaborate on tax status, most entities have what's called pass-through taxation. This means that the income isn't taxed at the entity level, but your share of the income and deductions passes through to the personal level. This makes the income subject to Social Security and Medicare taxes.

If you own an S-corporation, the taxation is also pass-through, but with some differences. S-corporation shareholders need to pay themselves a “reasonable” salary that satisfies the IRS. This salary is reported on Form W-2 with payroll and income taxes withheld. However, the profit distributions to the owners are not subject to Social Security and Medicare taxes.

C-corporations are not pass-through. The income is taxed at both the entity and shareholder levels. Officers of C-corporations need to be paid salaries reported on Form W-2 with payroll and income taxes withheld. Dividend payments are taxed at the dividend rate and are not subject to Social Security and Medicare taxes. 

Choose the Right Entity Structure 

Advisors Should Consider More than LLC vs S-corp

Selecting the right entity type often seems easy, it’s likely a limited liability company or S-corporation. You do a quick Google search, or hopefully have a conversation with your local CPA or attorney, and they’ll share their recommendation.

However, before making such an important decision, it is critical to make the selection in the context of your short- and long-term business plan and know that, when implemented correctly, you don’t necessarily have to pick one or the other, as there are options to leverage the best of both structures. It is important to not “over-engineer” a solution that is excessively complex now, for what you may eventually grow into needing two decades from now. You also want to be careful you don’t create something that will require significant retooling when you’ve had substantial growth and more business complexity, as making a change then will be significantly more expensive and time-consuming.

If you plan to operate a simple lifestyle business, not take on partners or successors, keep your staffing to a modest level, and not pursue inorganic growth through M&A, then the choices are simpler.

If you plan to grow, hire, add junior partners and share equity at some point, buy a business, or merge someone in, then you want a model that can scale with your changing business needs. The answer for most is still relatively simple but goes beyond an analog choice picking between an LLC or an S-corporation when setting up a financial advisory firm. 

Your Guide to Proper Entity Structure

Considerations for Independent Broker-dealers

Avoid Complications with an IBD

Advisors operating an independently owned Registered Investment Advisor (RIA) or insurance agency have the ability to set up their entity structure, and then like most businesses, engage clients directly with the entity. However, those operating under a corporate RIA or independent broker-dealer (IBD) for example, who hold licenses personally, are paid directly by the company in accordance with FINRA Rule 2040, regardless of whether they also have an operating entity they use.

In these cases, if you are using an entity, you have to find a way to compliantly move the funds from yourself to the company. On the surface, this step seems relatively innocuous. The IBD pays you and issues the 1099 at the end of the year, you then transfer the funds from your personal account to the entity’s account so you can operate your business. However, while this step is physically easy to execute – one cannot simply move money from one taxpayer to another. 

The  2016 tax court case, Fleischer v. Commissioner, dealt with this industry-specific issue. In short, the case involved a Nebraska-based financial advisor working under an IBD, who established an S-corporation, but like everyone else, he could only receive payments in his name due to Rule 2040. He then assigned these payments to the S-corporation, paid himself a salary, paid the expenses, and distributed the balance as profits to himself as the sole owner. Unfortunately, the IRS took issue with his setup.

In the end, the Tax Court agreed with the IRS that the payments were incorrectly assigned, causing Fleischer to pay over $40,000 in taxes, penalties, and interest as a result. However, the Tax Court made it clear what the issues were, all of which are addressable when one understands the nuances of the financial services industry and the minutia of entities and their governance documents. 

While there are layers of complexity with revenue assignment, it is almost a requirement for growing enterprises, and there are numerous advantages that you shouldn't have to forego. SRG's tax advisor partners can help you determine which structure is more beneficial. 

Setting Up Equity Sharing and Voting Rights for Your Firm

Many advisors form their primary operating entity initially when they are the sole owner, and thus spend little to no time thinking about things like multiple ownership classes with different rights/benefits, or how voting and decision-making will be handled.

Given they are the sole owner, it is understandable that these elements seem trivial and not worth paying an attorney to prepare agreements with additional features you don’t currently need. However, the entity is like the foundation of your house, you might only have one-story on the house initially, but if there is any chance you will want/need to expand and add a second or third story (the equivalent of adding more business complexity as you grow), it is important to create a foundation that can handle this, so we can avoid having to redo the foundation later.

SRG’s Team Solutions division works to help advisors set up robust entity structures for every clients, providing them with two or three owner classes by default, as well as carefully addressing and pressure testing voting powers – using SRG’s tools and resources to explore common decision that would fall under a unanimous consent requirement, supermajority requirement, and the remaining “minor” decision being left to a simple majority vote. The goal is to address how much control owners have, both majority and minority owners. 

Summary and SRG Entity Services

Planning your entity is of the utmost importance for every advisor, and as you continue to grow the book of business into an enterprise, the right entity and governance documents shift from something that is nice to have, to something that is critical to your ongoing success.

Financial advisors have highly specific concerns regarding liability, taxation, equity sharing, and revenue assignment that need to be considered when choosing the best business entity. Your entity not only needs to meet specific objectives but also consider long-term impacts and future growth. While an entity isn’t as easy to set up as many other small businesses, it is no less important and is something that can/should be done. Local tax and legal counsel will not understand the industry nuances or solutions, but in conjunction with the professionals at SRG, clients can expect to either fix their existing entity setup or form a new entity setup within a few weeks. 

SRG is a consultancy working nationwide, dedicated to the business needs of independent financial advisors. Entity planning and ongoing entity maintenance are best undertaken with professionals who are well-versed in the challenges unique to financial advisors. To dive deeper into this topic, we invite you to watch our webinar, Fueling Your Future: Unleashing Growth Potential through Entity Planning, and contact us regarding planning and optimizing your entity.

David Grau Jr.

Written by David Grau Jr.

David Grau Jr., founder and CEO of Succession Resource Group, specializes in succession and M&A consulting for advisors. As a leading M&A consultant with a history of service in the United States Navy, David is recognized as a thought leader and accomplished speaker. He is prominent in the financial services industry, especially on topics related to M&A and next-generation strategies, having delivered over 200 presentations for organizations like the Financial Services Institute (FSI) and FPA.