TRANSITION TALK

Professionals working in the independent financial services industry tend to organize their business the same way as other professional service providers. Whether a dentist, lawyer, or wealth advisor, chances are that the firm owner is both a full-time employee and an active manager of the business as well as a shareholder. We are often asked in our consulting work about this dual role; shareholder and employee, and the interplay between them, particularly as it relates to compensation strategies. For example, should employees be rewarded with stock, or the opportunity to buy stock for achieving certain targets? Or, now that I am an owner, shouldn’t I get a raise?  

There are no simple answers to these questions, but context should help to understand the thought process required to make informed decisions when these issues inevitably arise.

Salary vs. Profit Share

At a first level, ownership and pay are distinct concepts with unique rules, purposes, benefits and risks. These concepts represent the division between the return an investor receives on the capital put at risk and the reward received by an employee for the work that is performed. This division should be simple, self-evident and unbending, but the reality in a small business is often far different. The smaller the company, the harder it is to maintain a distinction between ownership returns and compensation. In the most basic model, a one owner company, the black and white lines dividing a return on investment and wages for work often disappear completely.

A large percentage of advisory businesses use some form of revenue-sharing arrangements, or an eat-what-you-kill system, that rewards sales and production tied to the top line, not the bottom line. This is true of small practices as well as larger businesses. “Fracture lines” are built into the practice model as individual books or practices are built in an environment that starts out collaboratively but most often ends up creating competitors. 

It’s important that independent advisors move away from obsolete practices and improper building tools held over from experiences in the wirehouse world. Creating a sustainable and valuable business should be the goal of every advisor. Building efficiently and effectively takes the proper tools, the proper structure, and the proper team.

Advisors need to embrace the most powerful and lucrative tool they have: equity. Equity is the value of the business separate and apart from the cash flow and compensation paid for work performed.

Probably not. 

When one person’s misstep in using a common industry practice gets reported in the press or a blog, a reader may worry if he or she has also strayed. Some have this response to the recent Tax Court case Fleischer v. Commissioner. The many differing opinions and commentaries on that case have advisors asking how this ruling affects their existing entity structures and tax reporting.

Many of the articles on Fleischer either oversimplify the court’s ruling, misinterpret the court’s decision to suggest an advisor with a business entity (either a corporation or a limited liability company) must abandon the entity, or miss the point entirely. The danger in those messages is their failure to understand the details of the Fleischer case, and not emphasizing that in the proper execution of an integrated plan – one that accommodates corporate law, tax law, and FINRA regulations – there would have been a different outcome.

From the Fleischer case, understand this: You won’t have a problem if you do things right. But setting up an entity in a highly regulated industry and operating it correctly is intricate. You cannot do it on LegalZoom or with an attorney or accountant unfamiliar with FINRA regulations. The Fleischer decision does not change the fact that entities are worthwhile for a wide variety of reasons.

The Fleischer Case

In the Fleischer case, the court focused on who controls the earning of the income, citing the two-part test recognized in the 1982 case of Johnson v. Commissioner. In that case, Charles Johnson played for the NBA’s San Francisco (now Golden State) Warriors in the 1970’s. He formed a Panamanian corporation to receive his income from the team. Citing additional precedent, the Johnson court held that the corporation did not meaningfully control Mr. Johnson’s services as a basketball player, nor did the Warriors have notice that its player was contractually affiliated with the entity. For those reasons, passing the player’s salary through the foreign corporation did not shelter Mr. Johnson from employment tax. The Johnson court stated two tests, both of which must be met:

Picture a bright orange life raft floating on a dark blue, storm-tossed ocean. In this durable, well-built, small craft sits an independent financial advisor. Our advisor has a paddle for propulsion – the means by which to move the raft to safer or more prosperous waters. Our advisor has the means to collect and store rain water for drinking, and fishing tackle to bring in food for survival – the craft literally is floating on a sea of food and fuel to sustain and propel its lone occupant. Our advisor also has a compass for navigation to guide forward progress along a chosen route. 

In terms of organizational structure, this sole proprietorship model is a common starting point for many advisors. With this model a single advisor is compensated on an “eat-what-you-kill,” basis–the clients are under his or her service; he or she receives 100% of the revenue to pay their own individual expenses, and takes 100% of the profits (if any) that remain.

To its credit, this basic production-based, or advisor-driven, model is extremely adaptable and simple to establish and operate. And while it may work for a single advisor office where there are only business expenses and compensation for one, it should not be mistaken for a building block for larger, more sustainable business models. Unfortunately, it often is.