Page 24 - Investment Advisor May 2021

RIA LESSONS & LEADERS

By Peter Nesvold and James Cofer

Buy, Sell or Grow? Company Structure

Challenges and Solutions

Tax and legal issues complicate the ability of S- and C-corporations to
finance growth, succession and/or liquidity. Here are some options.

hances are you have been buying back equity using company funds
approached multiple times and retiring the shares. However, it is not
Cabout selling or merging your just the selling shareholder who faces
investment advisory firm. These over- a capital gains tax bill; all S-corp share-
tures often prompt stakeholders of many holders — regardless of whether the indi-
successful wealth management firms to vidual sold any shares — are required to
consider, what is our long-term strategic pay a portion of the capital gains tax.
plan? Should we buy, sell or grow? If we
remain independent, how do we trans- What to do?
fer equity to next generation without So what’s an S-corp to do to finance
triggering substantial tax liability? growth and/or succession? Here are
Planning for growth, succession or some solutions:
liquidity involves a myriad of strategic • LLC drop-down. For S-corpor-
considerations. Unfortunately, a regis- U.S. citizens, legal residents, estates or ations that wish to bring institutional
tered investment advisor organized as a certain types of trusts. The restriction capital into the business, or for those
S- or C-corporation instead of a Limited against LLCs or C-corps as sharehold- that wish to create profits interests for
Liability Company faces additional lay- ers is a significant drawback because employees, one alternative is a so-called
ers of tax and legal complexity that most institutional investors — including LLC drop-down transaction: the S-corp
narrows future strategic options unless private equity — only can invest through forms an LLC as a wholly-owned sub-
proactively addressed. one of these two business entities. sidiary and transfers all of the firm’s
Limited options to create employ- assets to the new LLC. The new inves-
CHALLENGES AND SOLUTIONS FOR ee incentive plans. S-corps lack the tors then invest in the LLC, rather than
S-CORPS flexibility enjoyed by LLCs for creating the S-corp.
Prior to the rise in popularity of LLCs innovative employee incentive plans. The biggest drawback to the LLC
in the late 1990s, S-corporations were For instance, an LLC can grant a profits drop-down alternative is that the firm
among the most popular business enti- interest to an employee that entitles must notify all clients of the change
ties used for RIAs. Although S-corps the employee to a specific percentage in ownership structure. If the invest-
carried some known restrictions, the of the business’s profits. The distribu- ment agreements contain an affirma-
structure offered the limited liability tions will be taxable to the employee, tive consent provision, every client
protection of a C-corp but with only one but the mere act of granting the profits would potentially need to sign off on
level of taxation. interest is not. the transfer.
In the years since, the advisory busi- An S-corp may not offer a similar plan, • S-corporation inversion. An
ness has outgrown the S-corp structure largely due to the prohibition against S-corp inversion might be an attrac-
because it constrains firms’ ability to multiple classes of stock. Moreover, the tive option if an LLC drop-down would
grow and transfer equity to next gen new shareholder would recognize tax- trigger a disproportionate number of
managers. Here are some examples: able income at the grant date in the assignment consents.
Limited ability to raise institution- amount of the fair market value of the In this alternative, the shareholders
al capital. Most principals of RIAs orga- new shares. of the S-corp (“Old S”) form a new
nized as S-corps already are aware that Tax complications upon partial corporate holding company above Old
the number of shareholders is limited retirements of equity. Some RIAs cre- S; this new holding company makes Adobe Stock
to 100 and that all shareholders must be ate liquidity for a founding principal by an S-election (“New S”) and the Old S

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