How to reduce your tax burden when selling an RIA firm

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Speaker B: How our clients position themselves, frankly, to

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Speaker C: that we do business.

Speaker E: The industry of financial services is constantly evolving and facing new challenges. To succeed in this dynamic environment, you need to learn from the best and brightest in the field. Welcome to bank on Whiply, the podcast that brings you insights and best practices for those in financial services. In each episode, uh, we'll explore industry issues, hot topics, and current trends that affect your organizations. We'll also hear from experts and thought leaders who share their expertise and experience on how to stay ahead of the curve. Let's get into today's conversation.

Speaker F: Welcome, everybody. Today's guests are Dan Pastron and Corey Barbo, both partners here at Whipley. Dan and Corey, thank you so much for being here today.

Speaker C: Thanks for having us, Robert.

Speaker F: Yes, we're excited to have you both discuss how planning the best structures for the sale of your advisory firm can maximize the return to owners. We know both of you have considerable experience in helping clients with this area. Dan and Corey, would you provide our listeners some information about you and your role at Whipley? Corey, why don't we start with you?

Speaker D: Sure.

Speaker C: Thanks, Robert. My name is Corey Vargo. I'm a tax partner here at whipflii, and I'm also the firm's M and A tax leader, which means that I'm working on deals all the time, uh, specifically with RIAs, a lot of the issues that we see and a lot of the things that I focus on, uh, you know, may be common in other industries. But, um, in my role as the firm's M and A tax leader, I'm brought in and help advise on, uh, really RIA transactions of all sizes, um, from a few hundred million assets under management to, uh, billion. So very excited to talk about what we look at and how we bring value to our clients here today.

Speaker F: Thank you, Corey. Dan, how about you? Provide your background and experience for listeners.

Speaker D: Sure. Uh, so I too am a tax partner here in here at WIFLI in the financial service industry and I service many registered investment advisors. So I am dealing with this issue uh, all the time. And Corey and I work together in uh, supporting our clients getting through these transactions, whether it be a buy or a seller.

Speaker F: Well, thank you both. It's great for you to share your expertise. We certainly know uh, you are busy and we appreciate you taking the time to talk with us today. Why don't we start out. What are the most key topics relevant to tax that RA should be thinking about when considering a practice sale? Corey, do you want to start us off?

Speaker C: Yeah. You know, there are a number of important items that can impact the after tax cash value that a seller will see. Um, in other areas that will create other tax issues for sellers. Just a few examples. The legal entity structure of the transaction, um, you know, stock versus asset sale consideration, uh, potentially other structuring matters in the potential use of personal goodwill, um, protecting tax deferral or non taxability on rollover equity to the extent possible, which can be contingent upon uh, the RIA's legal entity structure or the buyer's legal entity structure. Allocation of proceeds to the seller shareholders, who's going to get cash, who's going to get equity, who gets how much of each, um, and other miscellaneous tax matters which can be very fact specific. But there are certainly a number and many of them you work through on pretty much every deal.

Speaker F: Well, there's certainly a lot to consider, Corey. I know Dan, you mentioned you have customers that are facing it. Uh, anything else to add to the list Corey just talked about?

Speaker D: Yeah. In this world also depending upon the entities, many of them operate in multiple states. So there are a bunch of state allocations you have to worry about as well. For sure. One of the things that we would be assisting with is, is looking at all those state allocations to see if there's a better way to structure some of these deals to avoid some multi state taxation and reduce the tax and not only the federal level, but obviously at this state level as well.

Speaker F: A lot to consider. Why don't we kind uh, of sort through them, take them one at a time. Corey, what should be top of mind from a legal entity structure?

Speaker C: Thanks, Robert. When thinking about legal entity structure, in most deals that we look at, a buyer is going to require an asset deal or a transaction that is treated as an asset deal for tax purposes. So pretty, pretty universal. Buyers want to buy assets, sellers typically want to sell stock in the RIA space. It is rare for a stock deal to happen, uh, so for the most part when we're talking about these matters, we focus our discussion on transactions that meet the asset purchase treatment for tax purposes. Um, and in that case the tax entity type or the legal entity structure or US Tax classification, um, of the targeted RIA firm is really important. If the company is an S corporation or a partnership for tax purposes, then we can typically get to a pretty good spot in terms of the overall after tax cash or deal value, um, and most of that vast majority of that constituting long term capital gains for the sellers, um, strictly on a, on a proceeds basis, uh, overall, you know, all shareholders together. But if the firm is structured as a C Corporation, there's a longer conversation that should be had regarding the planning into the transaction to avoid effectively double taxation in an asset sale which can result in a very high and often prohibitive effective tax rate. One thing we'll mention a couple times today that that does come up from time to time, including in a C corporation context, uh, is working around the identification of value associated with personal goodwill of the firm's shareholders and in some cases that that can be used to help eliminate or reduce double taxation, particularly related to C Corps. Dan, anything you'd add in terms of legal entity structure here?

Speaker D: No, Corey, you're right on point. Uh, when it comes to um, seeing these deals, if it's a partnership or an S Corp, certainly an asset sale is the best transaction that someone would want to buy, you know, by the assets of the company. Uh, interestingly enough, I believe on a, if it is a C Corporation and if it's appropriate to assign personal goodwill and if you're filing in multiple states, I believe the personal goodwill would only be taxed in the state in which you're a resident of. So there could be some benefits. Although we don't see C corporations in this, in these kind of entities a lot. There could be some other benefits that we could figure out at the state level to effectuate a better tax taxable transaction.

Speaker C: Uh, that's interesting.

Speaker F: So that's, that's the first item, uh, of I guess consideration for our listeners. I think you also mentioned rollover equity considerations, Corey and Dan, should we talk about that?

Speaker D: Sure.

Speaker C: So once a determination has been made or negotiations have been discussed related to the asset sale or the stock sale topic, um, sometimes together, but sometimes the next question that we'd look at is how do you preserve the non taxability or the tax deferral related to the role of equity associated in the transaction. Now keep in mind, um, if, if your firm will not become a platform for your investor or partner as a new investment in the RIA space or as a new platform for a parent company to potentially roll up other targets and even sometimes in that case, the odds are you're not going to simply hold on to a portion of the equity that you already own in your company. Uh, and there may need to be either a reorganization to achieve the overall structuring goals or an exchange of equity in your company for cash and equity in the buyer's parent or holding company for their RIA investments. Um, and so that can complicate things from a rollover equity standpoint and also open up the potential for taxability on rollover equity, which we certainly do not want for our clients that are on the sell side of a transaction like this, particularly when there's a significant amount of rollover equity, uh, and if that were taxed, it would potentially create a cash crunch when you're being asked to pay tax on something that you don't have the liquidity for. Now, structuring into non taxable rollover can be pretty standard for sophisticated buyers. Um, but sometimes a buyer, such as a publicly traded entity or for, for whatever reason, if the investors decide, uh, to have their RIA buyer call it in a C corporation context, may not be able to facilitate non taxable rollover in an easy way. We see that as an issue more frequently with a publicly traded company that is the purchaser. Um, so it's important to have an experienced tax advisor involved to ensure that the taxability of any rollover equity issued or retained as a part of the transaction is well understood and that the proper rules are followed if tax deferral on the rollover is the intention. Uh, you know, one last point that's worth mentioning is that when rollover equity is not taxable, currently that equity may need to be issued and held by the legacy RIA practice entity, uh, that the, that the sellers will maintain and continue to hold in perpetuity post transaction. Um, so there's nuances to that depending on the legal entity structure, whether your firm is in an S corporation, C corporation or other. Um, but just something to keep in mind that a lot of times S corporation structures require that an S corp survive as a holding company for rollover equity and that which we'll talk about maybe in a minute here, the legacy S corporation shareholders kind of play along, call it in perpetuity as common shareholders of that rollover um, but I'll pause there on the rollover equity and ask Dan if he would like to add anything here.

Speaker D: Yeah, what I would like to add is that, uh, it could be very complex and it's very important when rolling over any equity into the deal, that computing that tax basis of the equity that is rolling over, it's very important that it gets computed properly and then tracked.

Speaker C: Yes, that makes a lot of sense. Dan and I agree. In terms of tax basis, that's an important point because a lot of times professional services firms, RIAs, wealth managers will, you know, maybe you have a little bit of things like fixed assets, but it's typically not a big dollar amount. There could, however, be items such as receivables or accrued receivables that are on the cash basis for tax purposes. And almost always when you have an institutional buyer coming in to acquire a business, if there's rollover equity, there's going to be a conversion of cash to accrual. And under the accrual method of accounting, all those receivables would have to be picked up into income. And typically you can't preserve that legacy cash method treatment. And so understanding your tax basis and the assets you do have, what your tax basis and your rollover equity, as Dan mentioned, will be important, but also some other nuances that could affect the taxability of the deal, including usually a smaller portion, but a portion of the rollover equity if cash method of accounting is used prior to the transaction.

Speaker F: Um, sounds like definitely getting the right expertise involved, as, uh, both you are, both of you are saying is important. I know when we were preparing for this podcast, you also mentioned there might be some concerns with allocation of proceeds among sellers, both in terms of cash and that rollover equity you were just talking about. Should we talk, um, a little more in detail about that?

Speaker D: Sure.

Speaker C: And, you know, this is not an uncommon thing where a group of sellers are at varying stages in their career, and some may view a liquidity event as a retirement event, and others may view it as kind of a turbocharging event to help to accelerate the growth of the value in what they hold and what they do in their earnings potential. And when you have shareholders of an RIA that are in different places in their career, they may inherently desire to roll over more or less relative to their ownership in the firm and relative to their other shareholders. Um, and so Depending on the RIA's legal entity structure, there could be restrictions for either legal or tax purposes on how proceeds are allocated amongst the firm's shareholders. Uh, and there could be tax issues if the sellers need their proceeds to be in proportions that are different than their call it S Corp stock ownership. Um, and that's not just in terms of overall value but in terms of the percentage of cash received compared to the percentage of rollover equity retained. Um, for example, S corporations have to distribute proceeds in proportion to stock ownership. And non taxable rollover needs to be held by the S corporation in perpetuity as I mentioned, until it's ultimately liquidated. Now that means that you can't easily play around with disproportionate rollover amounts amongst the existing selling shareholders. Um, you can do some planning and some trading amongst the shareholders, but it's typically at the expense of efficiency on the rollover equity side or the non taxability of the rollover equity side. Um, and so deviation from these general rules can get messy. They should be analyzed in detail to maintain the most tax efficient structure. Again, even if you do lose a little bit of efficiency so that you can get to the right answer from a business and commercial standpoint for all of the shareholders involved on the sell side. And Dan mentioned that personal goodwill is a useful tool, um, and can be used in this context too. Even if the firm is an S corporation, if the shareholders, let's say, believe that there is maybe a disproportionate amount of value represented by one or two shareholders that have more experience or maybe some more pull with the client base, if the general consensus is that certain individuals should receive a value allocation greater than say their percentage of S Corp stock ownership, there could be personal goodwill value there to help as well.

Speaker D: I have seen in S Corp sales that let's say the young up and coming partner, potentially a bonus on the transaction to kind of even out how they want to divvy up the proceeds from the sale of the company. So things get pretty complex with S Corps. So you know, one of the things clearly when we're bringing in new clients and working with new RIAs, generally we would you know, speak to uh, speak with them a lot regarding entity structure. Generally we like LLCs with the ability to allocate profits based on the operating agreements. That would be our first preference. Second preference probably would be S Corps. Our third preference we would see, uh, or we would advise would be a C corporation. So because things get very complex once you get past the. If they're not an llc, things can get very complex in terms of divvying up the proceeds properly. So one of the things you'd want to look at is when you're getting into the business that you also have the proper exit strategy amongst all of your partners.

Speaker F: The discussion, maybe this is a quick question for both you. How early on should someone really think about this or how long would it take in the process or when should they get some. Someone like yourself involved in a transaction so you can start doing some of this planning?

Speaker C: Well, from my perspective, it would be in the case of a C corporation, well in advance, potentially several years in advance of a potential sale, just in the event that we would recommend making changes to the legal entity structure, uh, while the firm may be at a lower valuation than an exit value or uh, to maybe even have an opportunity to convert the company to be an S corporation. But I would say that for an S corporation or an LLC or a partnership that is considering going to market a few months before seriously pulling the trigger on going to market is probably the most ideal scenario. So that formal analysis can be performed, meaningful discussions can be had around what would be the tax effect of the various types of transactions that may exist or may occur. Um, and then being fully prepared for what may come when you go to market so that you're not scrambling, trying to understand things that we wish we had worked through earlier and being armed with that information will allow people to make the decision that's best for them without feeling like they're in a tight spot.

Speaker D: Yep.

Speaker F: Dan, do you agree?

Speaker D: Oh, absolutely. And you know, I certainly, when dealing with these clients through their lifetime, you know, from inception to selling, you know, these are questions that I bring up, you know, generally annually to find out. Many times these firms start out as one person and eventually build into larger organizations. So you want to continually, especially once an individual takes on partners and things are starting to get larger and more complicated, they certainly want to continually be looking at, if it's an LLC or a partnership, continually be looking at their partnership agreement to make sure that it's in sync with what they see their future as.

Speaker C: Uh, yeah, and Dan, you mentioned that you see transaction bonuses used from time to time with m maybe minority shareholders to get them a little bit more skin from the transaction. And if you have those conversations annually or at least in advance, well in advance of executing a transaction, uh, you may have more flexibility in terms of how you get the value in the right hands in a more tax efficient manner. Because it's great to be able to work into a bonus structure that puts everybody where they should be. But if you could get equity to people in a way that makes that capital gain rather than ordinary income to them, it just would create a lot more value that may not be there if you're trying to solve for that after the fact.

Speaker F: Sounds very similar to just general succession planning. Whether it's on the talent side or leadership side, this goes hand in hand, hand with it. So I think that's a good reminding, good reminder.

Speaker D: Great.

Speaker F: Maybe to one, it's probably a loaded question, Corey and Dan, but are there any other issues you see in an R transaction that you want to mention to listeners?

Speaker C: Well, you know, I'd say that in any particular deal, if you look back, you'd probably find something that was unique to that transaction. And even if you were to say, hey, personal goodwill was in more than one deal you worked on, you'd look at it from a different lens in one transaction compared to another. Um, but common issues that you see, uh, as Dan mentioned, include how do you handle transaction bonuses paid to employees if you do want to do something like that. And a lot of times people want to pay bonuses to people who aren't shareholders. And you know, that's meaningful and important when there's a lot of money coming in, um, for a transaction like this. And frankly a buyer may want that too from a retention standpoint. And so you know, from that particular standpoint, understanding who's going to get the compensation deduction for tax purposes related to that could be valuable. Um, another item is planning around the tax treatment of deferred sale consideration. So things like money that's placed in escrow for a holdback to cover indemnification, uh, there could be an earn out in a transaction and sometimes we just see a guaranteed portion of purchase price deferred for a year or 18 months or 2 years or whatever it may be. And making sure that we understand first of all, but also are able to plan into the most effective and efficient tax treatment for any of those types of deferred cash payments is important. Um, Dan also mentioned some state tax considerations. You know, I think Dan has got more experience than I do in terms of the multi state taxation of RIAs. Um, but sometimes what you run into, and I've seen from time to time is that certain states have certain special rules related to RIAs and banks or financial institutions, um, that in the most advantageous cases could exempt rias from state tax. Um, and you know, the question of whether gain on the sale of the business would be eligible or qualify for that exemption could be an extremely valuable item that could require research depending on the state that the company Operates in um, and the last thing that I'll mention here is very fact specific but if there are outstanding equity or debt transactions between the shareholders and the firm itself, you know, helping helping newer shareholders finance their buy in loans between the company and the shareholders or amongst the shareholders for stock purchases, cross sales, whatever it may be, um, the type of related party transactions that would need to be cleaned up pre transaction or in conjunction with closing are things that we see pretty frequently.

Speaker D: Corey, you're right on point. So Corey mentioned deferred sales proceeds and stuff like that for income tax purposes. Certainly in order to defer paying tax if it's over a period of years, you clearly would want to handle these as an installment obligation. You know, that way you could pay tax in the year you're receiving the proceeds. A lot to be said for handling these transactions in that way.

Speaker F: Well, thank you Dan and Corey. These are uh, great insights. I know given the breadth of experience you have, you've offered some good information for listeners.

Speaker C: Thanks Robert. And you know I, a lot of these things are very fact specific to the firm, to its shareholders. Dan mentioned tax basis a few times and especially when you, when you get into transactions that involve S corporations, rollover equity companies that have had stock purchases amongst shareholders or between the company and shareholders, tax basis is one of those tools that you may be able to use to create disconformity between the shareholders in terms of equity ownership or cash receipt, um, and other things that may help to get the shareholders where they want to be in ways that um, you may not have, especially in restrictive situations such as C Corp, S Corp, um, things of that nature. So I think my closing comment would be talk to a cpa, somebody who's a tax advisor that has experience in transactions and particularly the issues that RIAs face before you seriously consider taking your company to market for a third party investment.

Speaker D: And then I would add uh, with any type of transaction like these that we're speaking about today, um, the buyer is going to want to know everything there is to know about your company and the risk that they're taking when buying your company. So I think you have to be cognizant of what uh, I'm going to call deal fatigue. There are things that are going to slow it down, there are things that are going to. Other things are going to go smooth. Some things aren't going to go so smooth. But in the end if you're working with your professionals, we all can get you to the place where you want to be.

Speaker F: Well, I think Dan and Corey. That is. That is key really finding the right advisor to our listeners. Thank you for allowing us to share some ideas with you. As always, reach out with any questions or comments. We look forward to hearing from you and having you listen to our next podcast. Today's guests were Dan Pastron and Cory Vargo, both partners here at Whipley. Corey and Dan discussed items that could impact after tax cash or create other tax issues for an advisor or an rat firm that's selling. These include the legal entity structure protecting the tax deferral on rollover equity, the allocation of proceeds to seller shareholders, as well as making sure to take the time in advance to consider the impact of all of these tax issues.

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