Q52 – How to structure the legal ownership of an RIA?

Also available as podcast (Episode #52)

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How to structure the legal ownership of an RIA?

If you decide to start your own RIA, versus potentially joining an existing firm, one of the steps is setting up the RIA itself.  I have done a number of episodes on how that process works, how long it takes, the compliance partners you lean on to help you with it, etc.  In addition to the formation of the RIA, another important consideration is the legal ownership structure you plan to have for the RIA.  This is relevant whether you are a sole owner/operator, or part of a team of advisors.  There are a number of variables that should be understood and considered to make sure you are structuring your practice to reflect the needs of your current ownership situation, and also in preparation for possible future revisions/additions to it.

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Show Notes:

Richard L Chen PLLC Law Firm (website)

Richard Chen (LinkedIn | [email protected])

Full Transcript:

Brad: How to structure the legal ownership of an RIA? That is today’s question on the Transition To RIA question and answer series. It is episode #52.

Hi, I’m Brad Wales, with Transition To RIA, where I help you understand everything there is to know about why and how to transition to the RIA model.

On today’s episode, we’re going to talk about how to set up the legal structure of the RIA from an ownership perspective. I’ve done a number of episodes on how to set up the RIA itself from a logistical standpoint.

You typically work with compliance consulting firms or specialized attorneys that help you with that. There is a whole process, a whole timeline, steps involved of how you set up the RIA itself. Like I said, lots of episodes I’ve done, you can learn more about that.

What we’re going to talk about today is, and this is a question I get often, who can technically own the RIA? Can I own it in my individual name? Is that an option?  What happens if there’s me and other partners?  Can we set it up in the name of an entity, an LLC, or something like that? And why might we want to consider doing that?

That’s what we’re going to be talking about today because it is something that comes up quite often and is an important part of starting up your own RIA firm and checking those boxes.

So with that, I have a wonderful guest on today, any of those watching on screen can see, a good friend, Rich Chen, with the Richard L. Chen law firm. Rich, thank you for joining us.

Rich: Hey thanks, Brad. It’s great to be here.

Brad: I think we’re going to have a great conversation. I’ll ask Rich to give a background on himself and his firm here in just a second.

This is something that is important to think through, and this is the classic case of the blocking and tackling of starting up your own firm. There’s certainly things that are more exciting about starting up your own firm, maybe the marketing and how I’m getting a new brand, and how I’m going to position myself in the marketplace.

But there’s also a lot of check the box type things that are very important to get right on the front end. Not only because what might be required today, but also forward-looking of… “I want to position myself well because as things change over time, I don’t want to put up any hurdles in place now that could come back to bite me.”

Part of that is… “How do I set this up from an ownership structure?” That’s what we’re going to be diving into here. So Rich, if you can give us a brief background on yourself and your firm, I think that’d be quite helpful.

Rich: Absolutely, Brad. I’ve been a practicing attorney since 1998. I’ve been working in investment management for more than two decades. I founded Richard L. Chen PLLC, about two and a half years ago.

We serve predominantly SEC registered investment advisory firms with all kinds of strategies. We provide a broad scope of compliance, program development and management services, SEC mock audits, SEC registrations and representation, and SEC exams.

On the legal side, we help firms to structures their ownership, and compensation structures. We help them to review and negotiate commercial contracts with service providers, develop their own client agreements and employment agreements and manuals.

We also do M&A, joint venture, and succession planning work for advisors, as well as private fund formation and operational due diligence on funds.

Brad: Two things I’d point out.  One that Rich omitted, but I think it’s quite fair to point out, he is a Harvard undergrad and a Harvard Law School, so quite humble that you didn’t even mention that, but quite the credentials there from your background.

And then if you think…”He just named off a bunch of topics. Could he really be an expert on all those?” I’d encourage you, if you’re not already connected with him on LinkedIn – and today was no exception, I saw one of your posts from today – his knowledge runs wide and deep of the different topics he posts about and provides information on. So certainly, as part of this, find him on LinkedIn. You can learn from all of the content he’s putting out there.

Rich: Oh, thank you so much, Brad. It’s a joy to be able to be a resource and to be helpful to RIAs, whether they’re starting out or well established.

Brad: Terrific. Well, let’s dive in.

The first part of this question is – and maybe I’ll just keep referring to me as if I’m an advisor, I’m starting an RIA – how can I structure the formal ownership of it?

By the way, we’ll get the disclaimer out of the way at the top end. Some of these aspects you would want to bring in your CPA, your accountant as well to talk through what your personal tax situation is. This will be at a macro level what we’re going to talk about here.

Are there options to set it up in the name of the individual, you know, Brad Wales owns this RIA? Or do I have the option to have maybe an LLC own it and I technically own the LLC? So what are our options? And why might someone do one versus the other?

Rich: Great question, Brad. You can technically set up as an individual, although extremely few RIAs actually do that. And there are a variety of reasons for that.

The most important is that entities like LLCs and corporations allow you to have what’s called asset protection. And basically, when you look at an entity and sort of the business that you conduct through it, when the formalities are honored, it protects your personal assets. So your house and your retirement account, and all sorts of things from the potential reach of those that might be dissatisfied with the services that you provide.

Basically, the only thing that they can really go after are the assets in the entity. And so, it is a huge benefit. Obviously, insurance is helpful, but the structuring through an entity is helpful.

Another reason people do it is because they want to build an enterprise, build brand equity. If you have a name that you brand under or, you’re building an enterprise that you desire down the road to sell, that allows you if you do it through an entity to facilitate that process.

Brad: It’s interesting that almost any industry out there, you always think it’s an entity, and it might be the majority of folks now that do it, but I definitely see folks that have it still as an individual. These topics are something that should be taken to heart on that front.

With respect to the entity – and again, there’s tax considerations that you’d want to think through as well – is there any limitation to what kind of entity can be used? Is it only an LLC that is allowed? An S-corp? A partnership?  Is there any kind of regulatory limitations there?

Rich: No, there aren’t any regulatory limitations. There are certain entities like LLCs and corporations that provide you with the asset protection and so that is important. By and large, most RIAs set up as LLCs, limited liability companies.

The reason for that is because the LLC gives you a tremendous amount of flexibility in terms of how you structure your ownership, your rights, and there are some basic buckets of rights that we’ll go over later on. But (LLC) partners can contribute different amounts, receive different amounts in terms of profits or equity in the business. You have pretty broad flexibility in an LLC, but you have less flexibility in an S-corp, or a C-corp where there are disadvantageous with tax consequences. By and large, people set up as an LLC.

Brad: I assume with the LLC itself, there might be limitations on the number of owners you can have, what that ownership split is?  If someone for whatever reason wanted to have an individual or individuals as the owners versus an entity, or maybe a combination of the two, is there any minimums from a regulatory perspective?

For example….Rich, you and I, if we’re advisors, we start an RIA, is there anything that says, you own 99% and I only own 1%? Is there any minimum amount of ownership interests that the regulators require for someone to be called “an owner” or is it simply whatever works for the individual advisors?

Rich: Yeah, good question. No, there’s no limit. And that’s part of the beauty of the LLC is that flexibility. You can contribute as much. You can own as much as you want to. It’s total flexibility in terms of the owners.

A lot of people own it through individual ownership, but some folks will do it through entities like trusts. You can do your estate planning through your LLC, and if you worked with an estate planning attorney, it can potentially be advantageous from an estate planning perspective for folks.

And so, it’s definitely something to look at and to think about for how that can be beneficial for an owner’s tax circumstances. Another thing that can be beneficial is that you want to think about the fact that LLCs actually can be taxed as either a partnership or an S-corp. This is where it is important to talk to an accountant to figure out which election makes sense for the individual owner.

Even if it’s structured as an LLC, there’s a lot of flexibility on ownership and what tax elections that you take.

Brad: With all these reasons you just noted, why would someone still list the ownership directly in their individual name? Are they maybe just not aware of the option that they could do it as an entity?

And then to the degree, someone’s maybe watching this that already has an RIA that does have it under an individual name, and now has realized they have some options, can it be changed after the fact or is it decided only at the time the RIA is set up?

Rich: It’s a good question. I really don’t know what the benefit of setting up as an individual to own an RIA really would be. But the good news is that with some maneuvering, if you own an RIA individually, you can transfer the ownership to an LLC.

There are definitely certain things that you will have to do and to consider including potential assignment of client contracts or revision of the Form ADV and things like that, but it’s doable. So it’s not like you’re stuck if you’re owning a firm as an individual and you want to switch to ownership in an LLC. It’s doable. You just have to jump through some hoops.

Brad: So ideally, it’s something to do most effectively or efficiently on the front end, obviously, save on some costs and headaches to not have to change it down the road.

Rich: Absolutely, right.

Brad: On these episodes I’ve talked about setting up the RIA and talked about how long that takes. So, let’s say again, Rich, you and I are advisors. We’re starting up an RIA, we’ve watched this wonderful episode here and we say… “You know what? We should do this as an LLC.”

What is the process for setting up – for anyone that’s never done it – an LLC?  And how long does that take?  Is that a couple of days, a month, or what’s that look like to actually set up the entity?

Rich: The good news is that process can be relatively quick. You file what’s called a Certificate of Formation or Articles of Organization, depending on the state in which you organize.

You can get a next day turnaround if you want to, or even same day turnaround. And basically, once you file that, and you get evidence back from the state, then you are organized officially, but there are some other steps you need to do.

Typically, you want to get an Employer Identification Number, for a variety of reasons. You can apply for that online.

But the biggest step is that you will need to put together an Operating Agreement, particularly if you have two or more owners. That document lays out the rights of the parties, and there’s two buckets of rights.  Rights with respect to the management and decision-making, whether it’s on a day-to-day basis, or with respect to extraordinary decisions.

And then you have to allocate economic rights, with respect to the ownership of the entity, the equity in the business, as well as how you decide to divide up the profits of the company through distributions.

That’s why the Operating Agreement is the biggest step because it requires making decisions in terms of how the LLC will be governed and the decision-making that will take place.

Brad: Thank you for bringing up the Operating Agreement. I was going to bring that up, not because I’m smart enough to be an expert on it, but I’ve heard you talk about that before.

To be clear, that doesn’t go to the state?  That’s a private – you would know the legal term better than I do – that’s a private agreement between whoever the individual owners are, of… “Let’s memorialize what we’ve verbally sat down and agreed to of how we’re going to run this thing and how the economics are going to work.”

That’s only between those two parties, right? That doesn’t really get shared with anyone else, unless there was ever an issue?

Rich: It doesn’t get shared with regulators. Your bank may want to see it when you’re setting up the bank accounts. But, by and large, there’s no regulatory review, or approval of your Operating Agreement. That’s purely between the owners.

Brad: So the filing (of the LLC – for example) itself sounds pretty simple for someone that knows what they’re doing. But it’s that Operating Agreement that sounds like it takes a lot more consideration of thinking through all the variables.

Rich: There may be a couple other things to think about. If you organize in a state different from where you practice, you may actually have to also file an application for authority in the state where you’re actually doing business.

The other thing you may do, if you want to set up your RIA and doing business under another name, you may need to file certain fictitious name filings with the (applicable) jurisdictions to make sure that you can use the DBA instead of the legal name of the entity itself.

Brad: I’ve pointed out on a lot of episodes, I’ll point it out again here because it’s important to do so…no one should be intimidated by any of this. When you start your own RIA, or you maybe join an RIA firm, there’s a lot of steps involved in that process. That’s what I routinely help advisors with and understand.

In each one of those steps, there’s a defined process for how to manage it. You need to know what the process is, and know the people to lean on, to help you with that.

You might be taking notes on some of this stuff. But the idea – Rich is, obviously, an expert on this topic – is don’t be intimidated by this. What you need to know is that there are variables that need to be considered, and who do I lean on to help me understand all of that.

There are folks, Rich being one of them, that will walk you through all this and it’s nothing that you need to feel you’re not going to be able to accomplish, as long as you have that proper guidance. I think it’s important to keep that in mind.

Next question. As I’m talking to advisors who are thinking about starting up their own RIA, part of that conversation involves what the interaction is between the RIA and a custodian. I’ll point out why someone might be, as they say, single-custodian versus multi-custodian.

I saw a stat the other day, I think it’s like two-thirds of RIAs are multi-custodian nowadays.  I always point out to advisors that you might start single-custodian – because there’s some simplicity when you’re first starting up to do that – but plan for the long term. Plan for circumstances that might arrive at some point. I won’t go into it in this episode, but there’s reasons it might make sense for you to be, eventually, multi-custodial. So, don’t do anything on the front end that’s going to make it difficult for you on the back end to possibly take that perhaps almost inevitable step.

Circling back to this topic, how would that apply or what should advisors make sure they’re doing to not box themselves in?

I’ll give an example. If I’m an advisor, and right now it’s just me. Maybe I have a team of people, but I’m the only owner of the practice, and I set it up now. But who’s to say in 5 years, 10 years, 20 years, whatever the case is, there might be need for additional owners, or additional partners.

Any thoughts on things you should do on the front end to make sure you don’t make things more difficult on the back end with the expectation that your circumstances could change over time?

Rich: That’s a great question. I think the important thing to think about is the fact that these documents can and should evolve over time as the business does. You have to make sure that the provisions that allow for amendment of the operating agreement are sufficiently flexible and agreed upon by the members of the LLC, so that you can make those changes down the road because invariably that will happen. It’s important to have that flexibility.

It’s also important to have good dispute resolution mechanics. If the parties, especially, if there’s, let’s say, two owners with equal ownership rights, you need to have ways of managing disputes that are spelled out so that the parties can be happy that if they come into an issue that they have a problem with, that they can resolve it.

It is important to realize that these documents are living and breathing documents that will change over time.

Brad: That reinforces the importance of not taking the cookie-cutter Operating Agreement template off the proverbial shelf, filling in a couple names, and then thinking you’re all set. It’s worth the time and resources on the front end to do it right and so you have the needed flexibility for changes in circumstances.

We talked about how the Operating Agreement is a private document, and how it’s not necessarily shared, except for maybe a bank or whatnot. But the actual ownership of the firm, who all and where all is that disclosed? Whether privately, maybe directly to the regulators, or publicly in the ADV. Where is that ownership disclosed or who is it disclosed to?

Rich: It’s disclosed in Form ADV in Schedules A and B, and potentially C, if there are amendments. Anyone who owns more than 5% of an LLC or an RIA entity will be disclosed on the Form ADV. And if there’s an indirect ownership, let’s say an entity owns an interest in the LLC, the indirect owners would also be disclosed, if they own more than 25% of the entity that holds the LLC interest.

Brad: That could be a silent partner kind of thing, but because they own enough it would need to be listed?

Rich: Yeah, basically, they want to go up the chain…if there’s sufficient ownership of an entity, they want to understand who owns that. That’s right.

Brad: I’m a big proponent of always trying to be a straight shooter. I give pros and cons. Everything in the world, there is pros and cons to. Setting up under an entity structure seems to be the better way to do it for a lot of the reasons we just stated. But it can perhaps add some complications as well.

I’ll give an example, and then Rich, if you have any you want to add.

When I worked at a custodian during part of my career, I was on the committee that reviewed and approved any new agreements with RIAs that wanted to use that custodian for clearing services. That’s a pretty typical thing custodians do. You want to get comfortable with the custodian, they need to be comfortable with you.

Part of that is looking at who are the owners involved and maybe reviewing the CRD and things like that. If it was an entity that owned it, or maybe even more than one entity, we generally had to peel the onion back and ask…”who owns the entity?” And in what percent?  It slows that process down, and most custodians will want to break that wall down and say…”It’s an LLC, but now we want to know who owns the LLC.”

Any thoughts on that or any other circumstances you come across where an entity makes it more challenging that would be worth being aware of?

Rich: Well, I think that’s right. And I think custodians, and I would add banks as well, would probably want to know about the indirect owners. They want to know who they’re dealing with, whether it’s for anti-money laundering or other purposes. They’ll want to peel the onion back to understand who the ultimate people who are owning the entity and responsible for how it is being governed.

That being said, I think if you find that there are benefits, for instance, through estate planning, to have an entity, I think that those benefits, in my opinion, can far outweigh the hassle of having to explain who owns my entities that own my LLC. But it really depends on the circumstances.

Brad: Realizing there’s a couple of parties potentially involved in this, whether it’s the estate experts or accountants, is that something you typically see as you’re helping advisors get all this set up?

Rich: Absolutely. I strongly encourage folks to work at the very least with an accountant, because it’s critical to understand the tax circumstances of the owners of the entity, because there are important decisions to make.

It’s definitely not a cookie-cutter exercise to structure as an LLC, and to the extent that estate planning makes sense to bring those folks in. We help quarterback that process to make sure that all of these considerations give a full picture of what is best for the owners of the RIA.

Brad: There’s a lot of moving parts. And again, nothing to be intimidated by. It’s working through a defined process of how to manage this part of the setup of your own firm.

Any other takeaways? I probably haven’t asked every question that could be asked. You help folks with this, so you probably get asked many questions. Anything you think I haven’t asked that would be helpful for advisors to at least be thinking of initially, as they consider all of this?

Rich: There are a lot of decisions that are made. Especially when you’re putting together the Operating Agreement. Oftentimes, people want to address what happens if one of the members wants to leave or has to leave. Death or disability, bankruptcy, divorce, retirement of a partner, what happens in those circumstances? The Operating Agreement helps set some parameters for how those things will be handled in the event that those things take place.

Even from a day-to-day standpoint, as we were talking about the management of the RIA. Who makes day-to-day decisions? Who’s going to be responsible for what? Who can sign on behalf of the RIA on the management side?  People will have rights to consent or veto with respect to big decisions.

On the economic side, there’s decisions to be made with respect to profits, distributions. Potentially, you can have people who have a profit interest who don’t technically own the RIA. For instance, potential employees down the road that you want incentivized to stay with the firm, you can give them a profit interest without having an equity interest.

The other thing to think about is how you will divide up the equity between the partners based on what they contribute.

Lots and lots of decisions that help day-to-day governance. But also think about the worst-case scenarios. What happens if we don’t all get along, how are we going to handle things at that point?

Brad: That always comes back to how it’s much less expensive to try to tackle those things on the front end correctly than trying to potentially have to unwind something that gets messy on the back end, because it maybe wasn’t fully thought through on the front end. My guess is that can be exponentially more expensive on the back end if it’s not done right.

Rich: Yes.

Brad: One last question, I think we started talking about it and then got sidetracked.  If an advisor were to call you up today, and they want your help with this – some of that timing is in your control, Rich, some of that’s in the advisor’s control – but start to finish, what’s your ideal timeline if you were helping someone with this ownership process? And then the filings and all that stuff, what kind of window of time is ideal for this process to play out?

Rich: We can do the process in as little as a week or two, potentially, if we get all the information we need. But generally, I think it’s worth it to bank at least a month, in order to think through decisions. Particularly, if you have multiple owners, and you have to have discussions about how you want to handle things.

The way we do it is we provide an initial questionnaire to folks to help them think through a lot of the key decisions, and then they go back and have that discussion and come back to us. Between that and also coordinating with accountants and if necessary, estate planning attorneys, it takes some time to make sure that everything is done properly. So a month is a good amount of time.

Brad: As we wrap up, I’ve been bad about not pointing this out on all my prior episodes. I’ve got to get in the habit of pointing it out. I have Rich on the show. He’s not paying to be on the show. I’m not paying him to be on the show. I just think he’s a wonderful resource. I think this episode has proven that. There’s no financial interests, either way, or if I refer people to him, so just to be clear on that front.

But for people that are interested in this topic that like what you’ve said, and want to explore these topics further, what is the best way to get ahold of you?

Rich: I always welcome the opportunity to connect with people and to be a resource. You can email me at [email protected]. You can connect with me on LinkedIn. And our website is www.richardlchen.com.

Brad: I will make sure to include those in the show notes for folks that want to circle back.

And again, I’ve learned a lot myself following Rich on LinkedIn. So at a minimum, I encourage people to reach out and connect with him that way.

To wrap up, like I said, my name is Brad Wales with Transition To RIA. If you’re not already there, head on over to TransitionToRIA.com.  You’ll find the show notes, all kinds of episodes – both in video format, podcast format – I also have whitepapers. You can reach out to me. My contact information is on the top of every page of the website to reach out. We’ll have Rich’s contact information there as well.

Rich, thank you very much for coming on. These sorts of topics aren’t necessarily the sexiest of components to launching a firm, but they’re often some of the most important. So thank you for sharing your knowledge with us.

Rich: Brad, it’s been a pleasure. Thank you so much for having me.

Brad: Thanks, all.

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