Business entities affect taxes and M&A — how RIAs weigh the choice

With the number of registered investment advisory firms at an all-time high, more financial advisors face a decision about what business entity to file as at the state and federal levels.

Nearly three-quarters of firms have chosen to be pass-through entities that are limited liability companies, limited partnerships or partnerships, and just over a quarter elected to be corporations, according to the latest annual RIA snapshot report from the Investment Adviser Association, an industry trade group, and compliance firm COMPLY. 

The type of business entity used by RIAs affects their taxes and any potential future M&A deals, according to experts.

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The advisors whose breakaway moves from brokerages are driving the record volume of RIAs must "position themselves from the beginning for the most efficient way" to file as a business entity and "resist the urge to simply take a document that they found online or something that they've used before and use it again" to start a company, said Mark Wilhelm, a partner at the Troutman Pepper Hamilton Sanders law firm who works with RIAs. In some cases, advisors are more likely to fixate on retaining and building a client base or other aspects of opening an RIA.

"Any time that someone is starting a new business, they are really focused on the operations of their business," Wilhelm said in an interview. "It's not so exciting for an advisor to think about whether they themselves want to be formed as an LLC or corporation or how their entity is formed."

While there may be many factors that affect each individual RIA's selection, most these days are choosing to file with their respective secretaries of state as an LLC and submitting Form 2553 to the IRS to be an S-corporation for federal tax purposes, according to Leila Shaver, the founder of compliance firm My RIA Lawyer. The process "isn't hard," and it can be "done yourself, by an attorney or by your CPA," Shaver said in an email.

"An S-corporation is a pass-through entity for tax purposes. If taxed as an S-corp, the LLC doesn't pay corporate income tax. Rather, the profits pass through to the owners, who report and pay tax on the profit when they file their personal taxes," she said. 

"Meanwhile, C-corps file a corporate tax return and pay taxes at the corporate level," she continued. "With C-corps, you could also end up in a double taxation scenario if the profits are distributed as dividends to the owners. These dividends are taxable income and the individual owners would pay tax on it when they file their personal taxes. With the majority of RIAs managing under $1 billion in AUM, it simply makes sense for them to set up their entity as an LLC."

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At the end of 2023, 72% of RIAs were using some form of a pass-through entity structure — including the 62% out of the channel's total ranks electing to be LLCs — while another 26% were corporations, the industry snapshot noted. 

However, many of the founders of older RIAs are operating their companies as corporations, with 63% of firms established prior to 2000 filing as corporations. The Tax Cuts and Jobs Act and other tax policy changes over the years drove the shift, according to Shaver.

"Taxation as a C-corp was less than the individual tax rate," she said. "As the individual tax rate decreased and the margin between it and the c-corp tax rate diminished, we saw the increase in other entity-type formations. Once the limited liability company concept was created, the number of firms electing the LLC structure increased. Eventually, tax reform caused individual tax brackets to be less than S-corp taxation rates. As LLCs are pass-throughs to the individual shareholder, this became the better option. The number of LLCs skyrocketed; the number of c-corps diminished."

While the choice of business entity is "super-dependant" on individual factors, Wilhelm also said he would "suggest to any given person that forming as an LLC is probably the more efficient thing for them to do." Since the parties structure most industry M&A deals as asset purchases, prospective RIA sellers ought to be considering the implications of their type of business entity in any transaction. The taxes paid by C-corporations as part of any M&A deal pose "a situation that owners should know about and be concerned about," he noted. 

"The buyer of that business is going to pay the company whatever the deal price is," Wilhelm said, citing the example of a $50 million transaction. "At that point the owner of the company wants the cash, because they want to get the $50 million. It's ultimately going to flow up to the owners. What the owners should be thinking about is, what's the most tax-efficient way to get the money from the entity to themselves. … If they have a c-corporation in particular, then that's where that double taxation comes into play."

Wilhelm compared the question of whether to file as a corporation or an LLC to that of a retirement saver weighing the merits of an individual retirement account against those of a company-sponsored 401(k) plan.

READ MORE: Advisory firms hit record high count in 2023 as total AUM rebounds 

While it's "not to say one is worse than the other," but rather that "one provides a lot more flexibility" in the sense that 401(k) plan participants use the menu of investment options curated by their sponsor while IRA holders can invest in "most anything," Wilhelm said. Similarly, filing as a corporation carries requirements such as appointing a board of directors and company officers.

"There are a limited number of things that LLCs must do. It's significantly smaller than corporations," Wilhelm said. "It allows you to change it down the road much easier if you'd like to, because you're not stuck with that big book of rules for corporations."