LLC vs. Corporation. Which entity structure fits your goals?
Understanding your specific needs and specific goals is an important first step of the entity-building process. As Rod Boutin, JD, General Counsel at FP Transitions outlined in a recent webinar, “it is important that we build an entity that clearly identifies and promotes your attainment of those goals. Done right, an entity is a tool to align with your goals.”
Intentionally building the right foundation for your business always begins with identifying the best structure. As you do this, knowing where you are, and where you are going is very important. For many owners seeking to create a sustainable, multi-generational firm, one major advantage to forming an entity is the ability to transfer or sell small, incremental ownership interests to next-generation staff members. Establishing an entity structure and using it correctly can provide excellent continuity solutions as well as additional long-term strategic planning opportunities.
There are a lot of entity options: sole proprietorship, partnership, corporation (S Corp, C Corp) and LLC (Limited Liability Company). Choosing the right entity for your business comes down to understanding the benefits of entity, the pros and cons of each option, and your own short- and long-term business goals. Ultimately, a properly structured entity is foundational for growth and prosperity, as cash flow and value are directly linked through a practice’s organizational and compensation structure.
Sole Proprietorships and Partnerships have little to no formality in terms of operational structure. They are both taxed on the owners’ personal tax returns and they do not offer any liability protection. The only difference between the two is the number of owners.
This might work for financial advisors who run their practice alone–or with one or two other advisors–who have no plans to continue the business past their own career. But for business owners who have goals that include acquisitions, mergers, onboarding advisors, internal succession, and building enterprise value, you need a more formal entity.
A formalized entity provides the benefits of liability protection, perpetual duration, efficiencies, and pooled capital and operations. The rigidity of corporate governance, but also the simplicity of the structure is grounded by the process. Just by adopting an entity structure, a mindset shift occurs in the principals, tax efficiencies can be created, clear governance is established, and compensation options are expanded.
Corporations are formalized entities with two main types of classifications: C Corporation and S Corporation. Businesses with corporation entities default to C Corporation unless an S Corp designation is obtained. Corporations are registered with both the IRS and the state(s) where it operates. They have regulations regarding ownership structure and operations requiring a board of directors and certain operational officers. These entities are required to have bylaws and annual meetings. Owners of corporations are called "shareholders," meaning they own stock in the entity.
Generally, S corporations are a better fit for most financial planning businesses, as opposed to C corporations. In terms of taxation, C Corporations are subject to corporate taxes while S Corporations pass through profits and losses to its shareholders’ personal tax returns. S Corporations are also subject to additional ownership requirements including number of owners and citizenship.
Limited Liability Companies, or LLCs, are a formalized entity with more flexibility than corporations. Owners are called members and have equity stake in the business. LLCs are not subject to operational and ownership requirements and can conduct operations in however suits the business best. LLCs can be either manager-managed or member-managed, meaning the owners of the business could also be included in the leadership, or they could elect to hire leaders other than themselves.
LLCs also have flexibility in how they’re taxed. They can elect to be taxed as a sole prop (if there is only one owner), a partnership, a C Corporation, or an S Corporation. Depending on the election, this may subject them to certain restrictions, but its flexibility extends to changing this election year to year. LLCs are not taxed at a corporate level, instead profits and losses are claimed and taxed on the owners’ individual taxes. LLC owners may also be subject to self-employment taxes, including Medicare and Social Security. The flexibility of LLC entities can lead to complicated operating agreements, taxation rules, and ownership structures.
The most commonly appropriate entities for financial advisory firms are S Corporations and LLCs taxed as either a partnership or S Corporation. These formalize operations and ownership while maximizing taxation in a way that makes sense for relationship-based businesses of varying sizes.
Establishing a formal entity creates a solid foundation for both your organic and inorganic growth efforts. It also allows your business to leverage sophisticated compensation systems (including equity ownership) that support recruitment and retention efforts, formalize your ownership and operational structure to create efficiencies, and facilitate the free flow of human capital, which ensures that changes to your team or ownership won’t create a disruption of client service. You are also afforded the opportunity to consolidate with other entities, to merge with other entities, creating unique opportunities for growth that may fit with your long-term goals, which may include building value for the existing and exiting owners. As Ericka Langone, JD, Assistant General Counsel at FP Transitions said, “Certainly what is popular today is to grow your business through acquisitions, and we strongly believe that having the right enterprise structure can really help in making you a better, more attractive buyer. It creates capacity for growth and investment inside your firm, and it promotes sustainability so the business can live beyond just you.”
There are pros and cons to each type of entity. Making the right election for your business depends on your business’s unique circumstances and priorities. Establishing the proper entity can be simple and it can be complicated. It’s important to take the time to define business goals and understand your entity and taxation options to avoid a loss of time–and money– in walking back inappropriate entity selections. Let us know how FP Transitions can assist you in this important process.
“Making optimal choices at the right times is the foundation of enterprise growth.” -Rod Boutin, JD, General Counsel at FP Transitions