There are many decisions that breakaway brokers need to make when setting up their own firm, among them its business structure, which will have tax implications.
Should they choose to be an LLC or S corp, which are both pass-through entities whose earnings are not taxed at the firm level but as the income of the owner, or opt to be a C corp, a standard corporation that is itself taxed, separately from its owners?
Many breakaways avoid a C corp structure because of double taxation. The corporation pays taxes and so does the owner on the dividends that are distributed, but operating as a C corp may be easier for tax purposes.
Double taxation can also be an issue when selling a C corp unless the transaction is structured as a stock deal. In that case the proceeds of the sale would be taxed at the long-term capital gains rate, which is lower than the corporate tax rate. But the buyer would want to purchase the assets of the business, not the stock, in order to fully deduct the purchase price as well as the goodwill (customer-based relationships) that the seller could transfer to the buyer.
On the flip side, a C corp can simplify tax filing for firms that operate in multiple states. S corps and LLCs that operate in multiple states would have to file a personal tax return and corporate return in each state. “You can cut down on a lot of aggravation,” says Glenn James, a tax partner at BDO, a global accounting, financial advisory and consulting firm.
In addition C corps can provide tax-free health and accident benefits and a wide range of other fringe benefits deductible at the corporate level and not taxable for employees, even for the owner.
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But the pass-through taxation benefit of S corps and LLCs are attractive and could potentially become even more so if Congress passes tax reform resembling President Donald Trump’s plan. It reduces taxes on pass-through entities to 15%, which would be even lower than the proposed 20% corporate tax rate.
S Corps and LLCs provide another key benefit for advisors: They protect firm assets by limiting the firm’s liability for business activity, known as the firm’s contractual liability. But these structures do not protect a business owner from a tortious liability – one which harms another person as a result of negligence or intentional actions. A firm’s owner “could still be personally sued for giving bad advice,” said James.
Well over 90% of the new advisory firms that MarketCounsel helps to launch are setting up LLCs in either their home state or in a neutral state like Delaware, says CEO Brian Hamburger. MarketCounsel often defers the decision on the corporate structure to a new firm’s tax counsel or accountant, which it should already have arranged before consulting with MarketCounsel, says Hamburger.
“The choice of entity is less a legal issue and more of a tax issue because the limited liability feature of these organization is already a forgone conclusion,” said Hamburger, referring to a key benefit of LLCs and S corps.
His advice to a firm just launching as breakaway or otherwise: “Get a tax advisor. Look for an accountant with vast experience working with small businesses in particular… It’s not critical they have the industry knowledge, but it is important they have experience working with smaller partnerships or teams.”
Then the firm has to address its individual situation, says Hamburger:
- Who are the owners and how many are there?
- Where is the firm located? Firms have to focus on not only federal tax issues but also state tax issues, which is a major consideration in high-tax states such as California and New York. “You don’t just pay taxes on where the entity is domiciled but where it’s doing business.”
If operating in multiple states, a firm has to make sure it pays state taxes in addition to payroll taxes and registration fees at the state and maybe local level, says Hamburger. He notes that many advisors often forget about the use tax, which is essentially a sales tax paid by the user because the company that shipped an item to the firm didn’t collect any taxes.
Michael Cates, associate professor at the College for Financial Planning, says he often sees advisory firms choosing the S corp structure although LLCs are becoming increasing popular.
“That may have to do with the age of the attorney involved,” he said. S corps have been around longer, so older attorneys may be more comfortable working with that structure rather than LLCs given the many years of court decisions dealing with liability and tax issues, Cates explained.
There are many differences between the two structures that advisors should be aware of, including these:
- LLCs can have an unlimited number of members – the term used for owners; S corps can have no more than 100 shareholders (owners) and cannot have any foreign owners.
- LLCs with one owner are taxed as a sole proprietorship; with more than one owner they’re taxed as a partnership that can choose to pay taxes as an S corp or C corp.
- LLCs have informal operating agreements; S corps have a more formal structure including a board of directors, annual reports and other business filings, shareholder meetings and they generally operate at a higher level of regulatory compliance than with an LLC.
- LLCs can distribute income and loss disproportionately among the owners, based on operating agreement. S corps must distribute income and losses based strictly on their pro-rata shares of ownership. If flexibility is desired when divvying up profits among owners, the LLC is the preferred structure.
- LLC members are considered self-employed business owners rather than employees, so they are not subject to tax withholding. The LLC members pay self-employment taxes on all distributions, or 15.3%. S corps pay employment taxes only on the owner’s salary, which must be reasonable. The remaining net income can flow through to the owner free of FICA and self-employment taxes. This advantage of an S corp over an LLC is reduced if the owner is paid more than $127,200 annually because at that level no more Social Security taxes are collected, and those taxes, at a rate of 12.4%, make up the bulk of the 15.3% of income paid in FICA taxes. The LLC will still be paying the 2.9% Medicare tax, which has no wage limit.
- Another advantage of an S corp over an LLC: The maximum contribution to a defined contribution pension plan by the LLC member is limited to 20% when employees can contribute a maximum of 25%. S corp owners with a larger than 2% share of the business aren’t subject to the 20% limit.
- There are other differences between LLCs and S sorp involving the taxation of benefits such as health insurance and educational assistance — too many to discuss here.
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