Close Close
Sign In
Newsletters
Popular Financial Topics Discover relevant content from across the suite of ALM legal publications From the Industry More content from ThinkAdvisor and select sponsors Investment Advisor Issue Gallery Read digital editions of Investment Advisor Magazine Tax Facts Get clear, current, and reliable answers to pressing tax questions
Luminaries Awards
Podcast Center Video Center Webcasts Resource Center Events
About ThinkAdvisor Contact Us Advertise With Us Asset & Logo Licensing Sitemap Terms of Service Privacy Policy Copyright © 2024 ALM Global, LLC. All Rights Reserved.
ThinkAdvisor

Practice Management > Succession Planning

Buy, Sell or Grow? For S- and C-Corps, It‘s Complicated

By Peter Nesvold and James Cofer

X
Your article was successfully shared with the contacts you provided.

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.

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.

In this alternative, the shareholders of the S-corp (“Old S”) form a new corporate holding company above Old S; this new holding company makes an S-election (“New S”) and the Old S shareholders exchange all their stock for New S shares. Old S then elects to be a qualified subchapter S subsidiary, which is a disregarded entity for tax purposes. New S then forms a wholly owned LLC, which is initially disregarded for tax purposes, and Old S is merged into the LLC with LLC as the surviving entity.

The merger is not a taxable event because both Old S and the LLC are disregarded for tax purposes. Furthermore, depending on the applicable state laws, Old S’ business interests may transfer to the LLC with limited, if any, third-party consents required. Moreover, the RIA is now in a new LLC that can take on institutional investors, plus has the flexibility to create more innovative employee incentive plans that are typical of LLCs.

Convertible debt. A third option is to structure the investment as a convertible loan rather than as equity. Because the convertible feature of the loan does not constitute equity at the time of the initial transaction, this structure does not violate the S-corp rules until it is actually exercised.

Challenges and Solutions for C-Corps

C-corps also were popular among RIAs — particularly if they could not qualify as S-corps. If the RIA wanted to limit liability and had any foreign shareholders, for instance, or wished to structure multiple classes of stock for its owners, C-corps were often the default choice with key limitations.

Double taxation issues. Among the most obvious drawbacks of C-corps is the impact of double taxation: The RIA’s earnings are taxed at the corporate level, and shareholders are taxed again on dividends.

Many closely held C-corps circumvented this double taxation by distributing excess cashflow as compensation. However, this strategy can trigger Internal Revenue Service scrutiny for tax avoidance and does not work for outside investors who are not employees.

In the strategic planning context, however, the more significant obstacle is the inability to structure an eventual liquidity event as an asset sale without triggering a tax bill; a C-corp is taxed both at the corporate and shareholder levels upon this sale, whereas pass-through entities such as LLCs or S-corporations are only taxed at the shareholder level.

Many times, the choice of an asset deal is influenced by the acquirer’s desire to obtain significant tax savings by stepping up the assets’ basis to the purchase price (generally referred to as a depreciation tax shield).

Because these tax savings are measurable, the parties can calculate the net present value of these future cash flows and negotiate a split of the economics as part of the deal.

What to Do?

Even if the principals are not contemplating an exit or other liquidity event in the foreseeable future, the fact is that value is accruing inside the C-corp in a tax-inefficient manner. Here are tax planning alternatives to consider with a legacy C-corp.

S-corp conversion. One solution might be to convert the C-corp to an S-corp ahead of a more tax-efficient asset sale down the road. This solution is not as attractive, though, if the RIA’s ownership mix would violate the S-corp rules described above, or if the shareholders are contemplating a sale of the business in less than five years (the IRS’ required lookback period).

Drop-and-freeze transaction. One solution is a “drop and freeze” transaction through which the C-corp is dropped into a newly formed LLC.

The C-corp shareholders take back a preferred interest in the LLC (with little to no upside potential) and the junior or common equity in the LLC is sold or distributed to those stakeholders who the parties wish to participate in the upside of future growth of the business.

The value of the overall enterprise that is subject to double taxation is therefore “frozen” inside the C-corp as of the restructuring date, and any future value created accrues to the LLC, which is only subject to one-level of taxation.

In addition to preserving long-term value, this alternative also facilitates succession planning because the firm’s value overwhelmingly will be at the C-corp level at the time of the transaction. Therefore, equity in the LLC can be sold to next gen managers at low prices because the equity only has a claim on the future growth of the business.

Peter Nesvold is the founder of Nesvold Capital Partners. James Cofer is a partner of Seward & Kissel.

NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.