Chances are you have been approached multiple times about selling or merging yourinvestment advisory firm. These overtures often prompt stakeholders of manysuccessful wealth management firms toconsider, what is our long-term strategicplan? Should we buy, sell or grow? If weremain independent, how do we transfer equity to next generation withouttriggering substantial tax liability?
Planning for growth, succession orliquidity involves a myriad of strategicconsiderations. Unfortunately, a registered investment advisor organized as aS- or C-corporation instead of a LimitedLiability Company faces additional layers of tax and legal complexity thatnarrows future strategic options unlessproactively addressed.
CHALLENGES AND SOLUTIONS FOR
Prior to the rise in popularity of LLCsin the late 1990s, S-corporations wereamong the most popular business entities used for RIAs. Although S-corpscarried some known restrictions, thestructure offered the limited liabilityprotection of a C-corp but with only onelevel of taxation.
In the years since, the advisory business has outgrown the S-corp structurebecause it constrains firms’ ability togrow and transfer equity to next genmanagers. Here are some examples:
Limited ability to raise institution-
al capital. Most principals of RIAs orga-
nized as S-corps already are aware that
the number of shareholders is limited
to 100 and that all shareholders must be
U.S. citizens, legal residents, estates or
certain types of trusts. The restriction
against LLCs or C-corps as sharehold-
ers is a significant drawback because
most institutional investors — including
private equity — only can invest through
one of these two business entities.
Limited options to create employee incentive plans. S-corps lack theflexibility enjoyed by LLCs for creatinginnovative employee incentive plans.For instance, an LLC can grant a profitsinterest to an employee that entitlesthe employee to a specific percentageof the business’s profits. The distributions will be taxable to the employee,but the mere act of granting the profitsinterest is not.
An S-corp may not offer a similar plan,largely due to the prohibition againstmultiple classes of stock. Moreover, thenew shareholder would recognize taxable income at the grant date in theamount of the fair market value of thenew shares.
Tax complications upon partial
retirements of equity. Some RIAs cre-
ate liquidity for a founding principal by
buying back equity using company funds
and retiring the shares. However, it is not
just the selling shareholder who faces
a capital gains tax bill; all S-corp share-
holders — regardless of whether the indi-
vidual sold any shares — are required to
pay a portion of the capital gains tax.
What to do?
So what’s an S-corp to do to financegrowth and/or succession? Here aresome solutions:
• LLC drop-down. For S-corporations that wish to bring institutionalcapital into the business, or for thosethat wish to create profits interests foremployees, one alternative is a so-calledLLC drop-down transaction: the S-corpforms an LLC as a wholly-owned subsidiary and transfers all of the firm’sassets to the new LLC. The new investors then invest in the LLC, rather thanthe S-corp.
The biggest drawback to the LLCdrop-down alternative is that the firmmust notify all clients of the changein ownership structure. If the investment agreements contain an affirmative consent provision, every clientwould potentially need to sign off onthe transfer.
• S-corporation inversion. AnS-corp inversion might be an attractive option if an LLC drop-down wouldtrigger a disproportionate number ofassignment consents.
In this alternative, the shareholdersof the S-corp (“Old S”) form a newcorporate holding company above OldS; this new holding company makesan S-election (“New S”) and the Old S
RIA LESSONS & LEADERS
By Peter Nesvold and James Cofer
Buy, Sell or Grow? Company Structure
Challenges and Solutions
Tax and legal issues complicate the ability of S- and C-corporations to
finance growth, succession and/or liquidity. Here are some options.