LLC vs. Corporation. Which entity structure fits your goals?

LLC vs. Corporation. Which entity structure fits your goals?

Building a solid foundation for your business begins with selecting a legal entity and tax structure that will be most beneficial for your circumstances. When choosing the right entity for your business, it is important to identify both your short- and long-term personal and professional goals and consider the pros and cons of each option. Ultimately, a properly structured entity is foundational for growth and prosperity because cash flow and value are directly linked through a practice’s organizational and compensation structure. 

When it comes to legal entities, there are multiple options: sole proprietorships, partnerships, corporations (S Corp, C Corp), and limited liability companies (LLC’s). Sole proprietorships and partnerships do not have much formality in their operational structures and do not provide liability protection for their owners. These structures are most appropriate for financial advisors who manage their practice alone or with one or two other advisors and who do not intend for their business to continue beyond their retirement. 

For those seeking to create a sustainable, multi-generational firm, however, a legal entity is important so that the business may participate in acquisitions and mergers, onboard new advisors, build an internal succession plan, and create enterprise value. In addition, a formalized entity provides liability protection for the owners, clear governance, economic efficiencies, expanded compensation options, and pooled capital and operations. 

The two most common formal legal entity types are corporations and LLC’s.  Corporations are separate and distinct from their owners (also known as “shareholders” or “stockholders”) and provide legal protection for the corporation’s shareholders, directors, and officers. Most, if not all, states have adopted laws that require corporations to have certain operational formalities, such as bylaws, a Board of Directors, various officer positions, annual meetings of the directors, and annual meetings of the shareholders. A corporation may elect to be taxed either as a C corporation or an S corporation.

LLC’s are also separate and distinct from their owners, but they typically have fewer statutory requirements and therefore more operational flexibility than corporations. Owners of LLC’s are called “members.” LLC’s may either be managed by one manager or a small group of managers or may be collectively managed by all of the members. When an LLC is formed, the members typically adopt an Operating Agreement that serves as a roadmap for the management and operations of the business and a Members Agreement that serves as the continuity agreement among the members of the LLC. Depending on the circumstances, an LLC may elect to be taxed as a sole proprietorship, a partnership, a C corporation, or an S corporation. 

Given the typical needs and goals of financial advisory firms and the complex regulatory environment in which they operate, it is not common for a financial advisory firm to choose an entity taxed as a C corporation for its operating entity. More commonly, financial advisory firms choose an LLC or a corporation for their operating entity and elect for the entity to be taxed either as a partnership or as an S corporation.  

An entity taxed as a disregarded entity, a partnership, or an S corporation is referred to as a “pass-through entity.”  In pass-through entities, each owner is responsible for reporting his or her pro rata share of the entity’s profits and losses on his or her individual tax return. In addition, each of the owners may also be subject to self-employment taxes, including Medicare and Social Security. Entities taxed as partnerships have quite a few options under the Internal Revenue Code, which means they can be relatively simple or complex, depending on how the owners structure the business. Since an owner of an entity taxed as an S corporation may realize certain tax benefits, the IRS imposes requirements on those entities and owners, such as limiting the number of owners, restricting the types of owners to U.S. residents and certain trusts, and prohibiting the entity from issuing multiple classes of shares. However, those restrictions usually do not create complications for financial advisory firms.

Ultimately, there are pros and cons to each type of legal entity and each tax election.  Making the right choices for your business depends on your unique circumstances and priorities. No matter what you choose, establishing a formal entity for your business will help create a solid foundation for both your organic and inorganic growth efforts. Doing so will enable 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 build value for existing and exiting owners. In addition, an operating entity provides an excellent framework for building continuity solutions and implementing long-term strategic planning opportunities, ensuring  that any changes to your team or ownership won’t create a disruption of client service. 

Establishing–or restructuring for–the proper legal and tax structure for your business is paramount for your long-term professional success. It is important to take the time to define business goals and understand your options to avoid time-consuming and potentially costly maneuvers to undo inappropriate entity or tax selections. FP Transitions integrated teams of industry-specific entity and law experts can help you determine the most appropriate selection for you. Call us to set up time to review your business plans and discuss the right selection for you.