Your legal entity – make the best decision to protect your practice!
We recently outlined the advantages of teaming with other practice owners, particularly due to the competitive disadvantage of continuing to go it alone. Once you’ve decided to make the move to formally and legally join with others, the first thing you’ll need to determine is which legal entity is best for your new combined practice. This column will focus on the most common options available, and things to keep in mind as you maneuver through these legal and tax mazes.
From day one, you started your independent practice a sole proprietor – enjoying all the revenue and accepting all the risk. You’ve experienced the joys and pains of growth as you’ve built and managed your practice along the way. You are accustomed to running your business the way you want, with or without input from others.
If you decide to continue on your own, remaining a sole proprietor is still risky. If you have employees, you retain 100% of the personal liability. You also pay self-employment taxes on all your 1099 income. And utilizing the same group benefits with your employees is complex because you are forbidden from paying yourself a taxable paycheck. You should still consider establishing an authentic legal entity for your business model. Just make certain that you ‘can prove’ that your legal entity is real and just not an alter ego for your checkbook.
If, instead, you choose to combine your practice with another financial advisor (or more than one!), it will be critical to agree on how best to manage and protect your larger enterprise.
One thing you may not know – by default, you will remain a sole proprietor because your commissions (GDC) will continue to be paid to you by your broker dealer unless you are 100% RIA. Being a sole proprietor AND an owner of a legal entity automatically makes your tax situation complex, not to mention the risks involved in sharing your GDC with other licensed individuals. One mistake could easily knock you out of this business.
Many advisors decide to come together as partners – it’s a relatively straightforward structure, and the partnership model maintains the tax flow-through to the individual partners. Law firms generally use this model because it provides for unequal profit distributions, comparable to financial advisors having unequal books of businesses resulting in unequal distributions. It’s crucial to draw up a partnership agreement that clearly defines the responsibilities of each partner, decision-making limitations among the partners, how dissolution or transfer of partnerships will be handled, etc.
A partnership is more complex than a sole proprietorship, requiring more legal and tax attention and record keeping. Be aware that your partnership may default to state regulations in the event you do not have a valid partnership agreement and appropriate accounting records. As with any legal entity, you must always have job descriptions, owner agreements and accounting systems that reflect your actual business model, in case you are required to justify your business model to a regulator or court of law.
Unless it is possible to create a limited liability partnership, legal and financial risk in a true general partnership is joint and several, which could be bad for the partner with the most money, or the last one standing in a lawsuit. And using group benefits is difficult because owners are still prohibited from paying themselves taxable wages via a paycheck.
Partnerships may also create a situation through bankruptcy or divorce that thrusts upon you a new and completely unintended partner if protective agreements are not carefully drafted. Also, co-mingling GDC among licensed individuals will always be complex and risky, possibly even more so within a partnership model.
These types of legal entities vest ownership and control in the shareholders and board of directors. We do not see many C-Corps within the financial advisory world for a few key reasons: the potential for double taxation and the conflicts of interest that arise when ‘profits’ are created within a non-registered entity and then shared with licensed individuals, even when such profits are considered as retained earnings. Complexities also intensify when wrestling with equity terms and conditions, because equity in the financial advisory world is not a traditional form of ownership.
This model (along with the LLC-S) is by far the most common in the financial services industry. You enjoy the upside of growing your group practice while mitigating some of the downside risk of personal liability and tax consequences. The requirement to adhere to strict corporate formalities, such as the necessity of formal annual and regular meetings of shareholders and directors, is an added layer of complexity to consider when selecting a true corporate form. Failure to do so could result in your entity being viewed as an alter ego of the owners and could destroy the very liability protection it was intended to create. Profits and losses pass through to the individual advisor owner, and liability can be limited to the value of shares and personal guarantees.
You will need help from a lawyer, familiar and experienced within your industry and jurisdiction, to draw up the appropriate Articles of Incorporation and bylaws, and to ensure compliance with all state and federal requirements. Corporations fall under each state’s jurisdiction and the rules can be complicated. Corporate governance and acceptable accounting practices are essential. As a result, your expenses will be higher, with more legal and tax requirements than those in a partnership or sole proprietor.
S-Corp owners are allowed, and should in most circumstances, to pay themselves a reasonable salary for the work done for the practice. This should be documented within the employment agreement and job description. The IRS is very familiar with financial advisor business models, so make certain that your books and records are accurate and well organized in the event of a tax return audit. FINRA has also been looking at how advisors share income and expenses within a corporation.
Again, as with any legal entity in the financial advisory world, make sure your business is a real operating company and not just an alter ego for your checkbook.
Limited Liability Company (LLC)
The Limited Liability Company (LLC) is more common than all other entities because it may act to combine the benefits of a partnership (income flows through to the individual partners) with the limited risk of a corporation. LLC’s fall under state jurisdiction, so you’ll want to work with an experienced financial services-savvy attorney to set up your Limited Liability Company. State statutes also define the life expectancy of the LLC, typically 10-15 years.
As with all legal entity options, it’s critical that you create the appropriate agreements among the members dictating responsibilities, decision-making authority, succession, etc. Owners and employees must have detailed employment agreements and be bound by the same employment policies as dictated in your Employee Handbook.
The corporate formalities necessary in the pure “C” or “S” Corporation as described above are more relaxed in an LLC. LLC owners should, however, be sure to draft and execute an Operating Agreement, which determines voting rights, dissolution rules and a buy sell component among other things.
The LLC-S (S-Corp tax filing election) is necessary if you plan to pay yourself taxable wages within your LLC-S structure. This will help you streamline the facilitation of group benefits for you and your employees. Seek the guidance of a professional tax consultant familiar with how GDC flows from the broker dealer to you and then to your legal entity.
What’s the best option for you and the advisor(s) you are teaming with? We have years of experience, across multiple states, in helping advisors make the best choice in their legal entity – one of the most important decisions you’ll make as you grow and protect your practice. Make the right decision, and contact EmployShare. We’re here to help.
Dan D’Alio, President
Phone: (330) 856-9770
Jeffery Bovalino, JD, Business Development
Phone: (724) 843-3094
A single source solution to manage and protect your practice