What You Need to Know
- Many RIAs were organized as S-corps before the rise of LLCs in the late 1990s.
- RIAs organized as S- or C-corps instead of LLCs face extra tax and legal complexity when financing growth and succession.
- Corporate structures can often be changed with a bit of maneuvering.
Chances are you have been approached multiple times about selling or merging your investment advisory firm.
These overtures often prompt stakeholders of many successful wealth management firms to consider, what is our long-term strategic plan? Should we buy, sell or grow? If we remain independent, how do we transfer equity to the next generation without triggering substantial tax liability?
Planning for growth, succession or liquidity involves a myriad of strategic considerations. Unfortunately, a registered investment advisor organized as a S- or C-corporation instead of a limited liability company faces additional tax and legal complexity that narrows future strategic options unless proactively addressed.
Challenges and Solutions for S-corps
Prior to the rise in popularity of LLCs in the late 1990s, S-corporations were among the most popular business entities used for RIAs. Although S-corps carried some known restrictions, the structure offered the limited liability protection of a C-corp but with only one level of taxation.
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In the years since, the advisory business has outgrown the S-corp structure because it constrains firms’ ability to grow and transfer equity to next-gen managers. Here are some examples:
Limited ability to raise institutional capital. Most principals of RIAs organized 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 shareholders 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 the flexibility enjoyed by LLCs for creating innovative employee incentive plans.
For instance, an LLC can grant a profits interest to an employee that entitles the employee to a specific percentage of the business’s profits. The distributions will be taxable to the employee, but the mere act of granting the profits interest is not.
An S-corp may not offer a similar plan, largely due to the prohibition against multiple classes of stock. Moreover, the new shareholder would recognize taxable income at the grant date in the amount of the fair market value of the new shares.
Tax complications upon partial retirements of equity. Some RIAs create 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 shareholders — regardless of whether the individual 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 finance growth and/or succession? Here are some solutions:
LLC dropdown. For S-corporations that wish to bring institutional capital into the business, or for those that wish to create profits interests for employees, one alternative is a so-called LLC dropdown transaction: The S-corp forms an LLC as a wholly owned subsidiary and transfers all of the firm’s assets to the new LLC. The new investors then invest in the LLC, rather than the S-corp.
The biggest drawback to the LLC dropdown alternative is that the firm must notify all clients of the change in ownership structure. If the investment agreements contain an affirmative consent provision, every client would potentially need to sign off on the transfer.
S-corporation inversion. An S-corp inversion might be an attractive option if an LLC dropdown would trigger a disproportionate number of assignment consents.