Going independent? What an RIA needs to know about tax

It lurks at the bottom of the to-do list — if it’s there at all. But ignoring the thorny question of taxes can cost a newly-independent advisor dearly, especially in those crucial early years.

For advisors fleeing Wall Street banks to grubstake independent firms, making smart tax moves in addition to wrangling clients, a custodian, technology and payroll can boost the bottom line. Mess things up on the tax front, and the losses to a fledgling RIA “easily could be in the thousands or tens of thousands of dollars” a year, says Brian Nuttall, a CPA and lawyer at Kingsbery CPAs in Boulder, Colorado.

The biggest issue in going from employee to business owner involves figuring out which type of legal entity the new venture will take. Whether an advisor is fee-only or hybrid — earning fees for fiduciary-level service as well as commissions for transactions through a broker-dealer — the entity question is basically the same, according to Rick Wilkens, a CPA and partner at DeMarco Sciaccotta Wilkens & Dunleavy, an accounting and business advisory firm in Tinley Park, Illinois.

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LLC or S corporation?
Many RIAs establish a limited liability company, a type of “pass-through entity” that doesn’t itself pay tax but instead funnels its profits to the owner, who pays tax on them at ordinary-income rates (the highest rate is now 37%). They’re usually an easier type of entity to deal with on the legal front, which is regulated by the state in which they’re set up, and generally have less stringent record-keeping requirements compared to S corporations, another type of pass-through. LLC members don’t receive a salary, but instead get compensated through profit distributions.

But such advisors can face a rude shock when they realize that in addition to individual taxes, both federal and state, they also owe the 15.3 % self-employment tax, for Social Security and Medicare costs that their previous employer deducted from their paychecks.

Still, that tax can be avoided. The sidestep comes when a member, as LLC partners are known, elects for the LLC to be taxed like an S corporation.

With an S corp, the owner or owners pay themselves what the IRS requires to be a “reasonable salary,” at least half of the total amount due the advisor, Nuttall says, then distribute the firm’s profits to themselves. The salary bears a payroll tax that is functionally the same thing as an LLC’s self-employment tax, but the distributions — hopefully a chunk of a newly-independent advisor’s income — do not. And those “reasonable” salaries are deductible by the owners as a business expense on their personal returns (the distributions are not deductible). Even though it doesn’t itself owe tax, an S corp has to file a return. “There are real savings with an S corp,” says Nuttall, who specializes in tax issues for advisors.

But the S corp tax benefit comes at a price.

This structure makes it harder to bring in new partners (like your former colleague who also wants to leave the wirehouse). That’s because they engrave in stone the percentage of profits and losses that are allocated to owners, called shareholders. According to Nuttall, a new owner either has to pay the fair market value for the shares purchased or pay tax on the value of the shares given to them, as well as undertake the cumbersome paperwork of changing the wages paid to current owners. By contrast, an LLC is more flexible, and can simply pay out a different amount in profits every year.

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In 2019, the IRS heightened its scrutiny of S corps and began requiring their returns to include details on how profits and losses were calculated when paying out distributions or assigning losses to owners.

And the entity can cause confusion with vendors that an RIA deals with and prompt “another layer of explanation. It’s occasionally, what are you? It says LLC, but you’re telling me an S corp.”

Still, Nuttall is a fan of starting with a S corp, to capture the tax benefit. “It’s not my advice to start with an LLC.”

More than 3,050 advisors abandon wirehouses each year, while nearly 3,800 depart regional broker-dealers, according to research firm Cerulli Associates data cited by Fidelity Institutional in a November report.

But service platforms, like Dynasty Financial Partners and RIA in a Box, that help RIAs set up and run their technology, compliance, investment operations, billing, marketing and all the other functions they didn't have to deal with at a broker-dealer, touch lightly, if at all, on tax issues.

“Unless you know tax yourself, you need an attorney or tax advisor for entity selection,” says Eric Gabor, a CFP who is the founder and owner of Eagle Grove Advisors, a fee-only firm in Jersey City, New Jersey.

If you’re thinking of going independent, experts say, consider these other tax issues as well:

Quarterly tax payments — Unless they elect S corp treatment, single-member LLCs are taxed as sole proprietorships, and multi-member LLCs are taxed as a partnership. Either way, those individuals as well as advisors who set up an S corp need to make quarterly estimated tax payments to the IRS for the expected tax bill on their income and distributions.

You probably need an accountant — Requirements by state regulators and, for RIAs managing at least $100 million in assets, the SEC to keep track of balance sheets and income statements may make you long for your old wirehouse days, when a back office took care of it. “The last thing we want to do is our own business finances when we spend all day in other people’s finances,” says CFP Sophia Bera, the founder of Gen Y Planning in Austin, Texas. “I hired a bookkeeper after eight months, and it was the best money I ever spent.”

If you pay people wages or a salary, you need to deal with payroll taxes and withholding. Cue that accountant. “It’s not something you want to do yourself,” says Gabor, adding, “QuickBooks is easy to mess up.”

Consumer use tax— That levy is imposed by states on a buyer when purchasing something from an out-of-state vendor who doesn’t collect sales tax on the transaction. It can hit hard goods, like computers or office furniture, as well as software licenses.

Retirement plans and health insurance — A solo (401)k is often a smart choice for breakaway advisors because the annual contribution limits are much higher than for a corporate 401(k) — for those over age 50, up to $58,000 this year vs. $26,000.

“The tax stuff kind of gets put on the back burner,” says Wilkens. “But it’s always that the tax planning piece done early on can save money and aggravation.”