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.

LLCs have no such requirements. And, says Halpin, all but an LLC’s managing member may remain undisclosed in the firm’s articles of incorporation. S-corp. shareholders enjoy no such anonymity. Also, unlike S-corp. shareholders, he notes, members of LLCs cannot be enjoined in lawsuit against their firms.

Because of these advantages, sources say, an LLC structure, taxed as a sole proprietorship or partnership, will make sense for most advisors starting a practice. But after reaching a certain size–Underwood pegs the threshold at $100,000-plus in annual income–then an S-corp. election should be considered because tax benefits grow in proportion to revenue.

The owners of both LLCs and S-corps., observers note, are subject to self-employment, Social Security (FICA) and Medicare taxes. But S-corp. dividends are distributed income tax-free. Thus, the larger are the distributions relative to salary-based comp, the greater is proportion of income that flows income tax-free to the owners.

“In S-corps., the object is to pay yourself as low a salary as you can justify and pay out the rest to the owners of the enterprise,” says Underwood. “It truly is a game.”

Such games can only be carried so far before falling under IRS scrutiny.

Chris Cooper, a CFP and president of Chris Cooper & Co. and ElderCare Advocates, Toledo, Ohio, cites a tax court case in which the S-corp. owner of an accounting firm paid himself $35,000 annually–but $200,000 in dividends through the firm. He won the case, arguing that he could hire an accountant for the same pay. But Cooper cautions that owners of S-corps. (or LLCs taxed as S-corps.) need to take care to pay themselves a “reasonable” salary if they hope to avoid an IRS audit and tax penalties.

Salary-based compensation is also necessary if the owners intend to set up a pension plan for themselves. And pension plans in LLCs taxed as an S-corp. enjoy a more favorable tax treatment than they do when taxed as a partnership. Whereas, Cooper says, pension contributions under the former are deducted pre-tax, in the latter case, the contributions are made after tax.

“The advisor in an LLC [taxed as a sole proprietorship] who reports $60,000 in profit on a Schedule C and puts $15,000 of this amount into a pension plan pays 15.3% in tax on the $15,000,” says Cooper. “But if he incorporates and pays himself $45,000 in salary and puts $15,000 into the pension, he saves 15.3%. So there are good tax reasons for incorporating.”

At least for now. Pensions aside, Underwood points out that the recently passed health care bill will likely equalize the tax treatment of S-corps. and LLCs by subjecting S-corp. dividends to Social Security tax.

“I expect that LLCs will be favored even more going forward because the need to reduce Social Security taxes will probably be significantly diminished if the health care law stays in effect,” says Underwood. “The IRS has long objected to businesses avoiding FICA tax just because they’re an S-corp., whereas LLCs have to pay it.”

One thing S-corp. owner-shareholders can’t avoid is preparing an exit or succession plan for their businesses. Mark Brown, a certified financial planner and managing partner of Brown & Tedstrom Inc., Denver, Colo., says that owners planning to sell their practices can amortize personal goodwill: intangible assets valued according to the advantage or reputation the practice has acquired beyond its tangible assets. Upshot: The owner can maximize after-tax proceeds from the sale.

Taxes aside, sources say that advisors need to consider whether the state recognizes the favored business entity. Whereas all states recognize the S-corp., the same can’t be said of LLCs. This can be an issue not only within the state where a commission-based agent principally does business, Cooper notes, but also when selling products in neighboring states.

“For many agents who earn income from commissions, crossing state lines can be a nightmare if the LLC isn’t recognized in the other state,” says Cooper. “What I see happening in coming years is that now independent registered reps will become W2 employees of their broker-dealers. The reps’ independent companies will then have to operate in some line of business.”