Starting a New Practice? Don't Forget About the Tax Type

Producers looking to establish an independent practice often do not place a high priority on figuring out what tax type the business will be. But they should.

That, sources tell National Underwriter, is because the taxable nature of the business entity has significant implications for the operations of the firm and, ultimately, the impact on the bottom line. Such key issues as compensation, corporate governance and administration, exit planning, the ability to operate across states or to change the tax treatment–all hinge on how the business is set up.

Traditionally, business owners who chose to form an entity to protect personal assets but allow income/losses to be reported on a personal tax return had to create an S-corporation. Today, that can also be accomplished with a limited liability company. And, observers say, the LLC is now the preferred entity among advisors because of how it blends elements of the corporation, partnership or, in the case of an individual owner, the sole proprietorship.

“The LLC is really the best structure for a privately held business,” says Joseph Halpin, a certified financial planner and principal of J.P. Halpin LLC, West Chester, Pa. “It has grown increasingly attractive in recent years and, in my view, is superior to any other company form.”

“These days, the S-corporation is rarely the business entity of choice among newly independent advisors,” adds Jim Underwood, a certified financial planner and managing partner of Tarpley & Underwood Financial Advisors LLC, Atlanta, Ga. “You have so many more options available to you by structuring your business as an LLC.”

A chief attraction of the LLC, sources say, is its flexibility. When setting up a practice, the advisor can have it taxed as a sole proprietorship, a partnership or, if as a corporation, by making a C-corp. or an S-corp. election. If a sole proprietorship or partnership tax treatment is selected, the advisor can later switch to an S-corp.

Not so if the advisor decides initially to set up as an S-corp. If an alternative entity is desired later, the only option is to dissolve the business and start anew under the preferred business type.

(In all cases but a C-corp., the business would be taxed as a pass-through entity, meaning that income flows to the owners or investors. That allows them to avoid double taxation, or the imposition of income tax on the individual and the corporation, as in the case of C-corp. owners.)

The LLCs added flexibility, market-watchers say, extends to the compensation of the principals. If each of two advisors owns a 50% share of the business, but one merits more compensation than the other, then the company can make, in lieu of a salary, special allocations known as a “guaranteed payments.” Additional income flowing to the owners (say, at year-end) can be divvied up according to their respective ownership shares in the firm.

For S-corp. owners, the only way to vary compensation paid to principals owning equal shares of business is to fix their salaries at different levels. (All S-corp. owners, per IRS rules, must receive a base salary as part of their compensation, which may also include dividends paid to them as owner-investors.)

Paying income tax is also an easier process for limited liability companies, say experts. In contrast to S-corp. owners, who have to file two tax returns–one for themselves, and second for the corporation–LLC members only submit an individual income tax return (IRS form 1040, Schedule C for sole proprietors; IRS form 1065 for multiple-owner LLCs that are taxed as partnerships).

The LLC boasts other advantages. There are, for example, no restrictions on the number of member-owners. In contrast, federal law caps the number of S-corp. shareholders at 100. Stock ownership is also limited to individuals, estates and certain trusts (such as a small business trust).

And like a regular C-corp., the S-corp. is subject to greater administrative and operational requirements. The S-corp. must elect a board of directors and officers, hold annual meetings of its board of directors and stockholders, file an annual report, and keep corporate minutes.

“S-corps have a lot of formalities to deal with,” says Halpin. “That’s important, because in a lawsuit those formalities could become an issue that allows a creditor to pierce the corporate veil.” Translation: If a court so decides (as in cases involving fraud or other wrongful acts), the business can no longer be used to shield its owner-shareholders from personal liability beyond their investment in the firm.