As an investor for over 9 years and LLC co-owner for over 5, I’ve thought a lot about utilizing my passion for investing in the most optimal way. Maybe you’re thinking of starting an investment firm, wanting to invest on your own or on behalf of others.
Well, there’s so many ways to do it, and it can feel so complex…
Here’s the key points from some of my research. I’m not a tax expert or corporate lawyer, so don’t take this as a legal recommendation. However, I’ll narrow it down, so you understand the big picture hurdles around investment firms and vehicles.
For starters, let’s observe what one of the greatest investors of all time has done with his first investment company– Warren Buffett.
What’s interesting about Buffett’s case is that he went 2 different directions with investment management, first owning his own Limited Partnership and then closing it down in favor of owning stocks in his corporate conglomerate, Berkshire Hathaway.
Before we discuss why Buffett made the switch from Limited Partnership to Corporation, let’s get some confusing legalese out of the way.
- A corporation is different from an LLC
LLC stands for Limited Liability Company, and not Limited Liability Corporation, which was something I got confused on for a while. Maybe you’re smarter than me and didn’t have this issue.
- You can invest (buy stocks) in all sorts of ways: for yourself in a brokerage account (or even as a daytrader with margin), as an investment firm where you manage assets for clients, as an LLC for yourself, as an LLC for yourself and others, as a limited partnership for yourself and others, and finally, as a corporation for yourself or others.
- Here’s what gets even more confusing. Your legal status and tax status for an investment vehicle can be two different things.
For example, you could own an LLC but be taxed as a sole proprietor, where the income is essentially taxed as pass through, as if it was just like self employment income.
And, all the taxes and legal technicalities can really be discouraging and challenging to learn if you’re considering starting an investment firm, but it’s really important. In this process, you could have your accountant to tell you to ask a corporate lawyer and have your corporate lawyer tell you to ask an accountant. So at the end of the day, you still have to know enough about some of the basics, you can’t just hire and delegate it away (at least at the start).
Yeah, how annoying.
But I want to get to the fun stuff and talk about building up stacks of money through the great vehicle of investing. The fact of the matter is that knowing how to allocate capital properly through investments is an extremely valuable skill, and can make you discriminatory amounts of money if you’re good at it.
So what do we need to know?
I want to go back to the story of Buffett again because it really teaches great lessons on the pluses and minuses of various investment structures.
Lessons from Warren Buffett’s Limited Partnership
Warren Buffett started managing money, in 1956, as an investment firm that he structured as a limited partnership. He charged 25% of the profit for his services.
The jist of Buffett’s limited partnership was that he pooled money from friends and family, charged them a small fee to manage that money, and then made money for the firm by buying great stocks as investments.
In essence, we can think of the standard limited partnership structure as we would a mutual fund, where investors can enter and leave the fund, and as the fund’s NAV (net asset value = the value of the investments held in the fund) grows, the value of the shares in the fund that investors hold also grows.
Okay, that’s cool, so why did Buffett abandon the limited partnership model?
Well, Buffett started getting complaints from investors about income tax liabilities when investments in the investment company were sold (what a problem to have, a manager making such large profits for you that you have to pay taxes on it!).
But, it’s a valid complaint and consideration. After all, some (hopefully most) investors are in it for the long term and aren’t necessarily concerned with receiving short term benefits from their investments, and would rather let that money sit in the fund so it can continue to compound.
Well that’s where the corporation model comes in.
Basics of Taxes in a Corporation
In a corporation that’s formed for handling investments, instead of taxes on investments getting passed through to the investor (capital gains and dividends taxes), the corporation is hit with the taxes and this comes out of their Net Income.
To me, the corporation structure is the easiest to understand because it’s how the companies in the stock market operate.
As you should know because you are starting an investment firm, corporations can (and do) hold marketable securities on their balance sheet, and any dividend income or gains from selling those securities gets recorded in the income statement and cash flow statement. Once everything on the income statement processes through– from the top line to EBITDA to the taxes– you have the final Net Income number that investors love to fixate on.
The corporation can then reinvest those earnings as they see fit, either back into core operations of the business, to pay down debt, to buyback shares, and to pay dividends.
Shareholders of the corporation, then, are only taxed on dividends they receive or if they sell their shares in the corporation, which allows much of the investment gains made from buying and selling securities like stocks to avoid a “double taxation” effect.
Contrast this back to the limited partnership…
Every single time Buffett sold a stock for the partners at a profit, the capital gains would pass through to each of the partners. That meant a tax bill for these partners every year, regardless of whether the partner actually withdrew money from the partnership or not (instead re-investing it, perhaps).
Having to deal with these type of partnership taxes meant less (potential) compounding opportunities for partners at the personal level.
How to Start an Investment Company (as a Corporation; aka “Corporation Inc.”)
Now, you can pool friends and family and distribute shares to them in a corporation just like you can in a limited partnership. But if you do this, there’s a few things to keep in mind.
This great article summarized many of the advantages and disadvantages of starting a corporation, which apply the same to starting a corporation for investments.
Disadvantages to an investment corporation include:
- Potential double taxation (taxes on income for the corporation, taxes on dividends for shareholders)
- More documents required for a corporation rather than a company (like an annual report)
- Potential holding company tax (more on this below)
Advantages to the corporation versus a regular LLC (or LLP) for your investment firm vehicle can include:
- Management can choose not to pay a dividend to avoid that taxation to shareholders (like Warren Buffett does with Berkshire Hathaway)
- Generally, more flexibility on buying and selling shares for shareholders (which can be another way for stakeholders to control their tax bill)
- A corporation can issue shares easily to raise capital, vastly improving the potential for quickly scaling the operations
Let’s say there’s no interest starting a corporation, but you’re still open to the LP (limited partnership) model or the LLC (limited liability company) model. Let’s compare those.
Starting an Investment LLC vs Limited Partnership
Finally there’s the option of starting an investing LLC. I’ll summarize a “typical path” for the LLC, which you can see will be very similar to the LP.
Say you want to start an investment LLC, and take in money from investors.
Like with the limited partnership that Warren Buffett had, each limited partner will be taxed on any profits generated from the LP (such as capital gains). For the LLC, it’s the exact same way, as each owner will have profits passed through to their personal taxes as well.
For both structures, the “limited” nature of the ventures means that liabilities are limited for the partners (LP) or owners (LLC).
That means if the manager of the LP/LLC decides to take on a bunch of debt and/or generate massive losses, the limited partners/owners have limited liability (are not liable).
As this article explains, profits can be divvied up differently in an LLC vs an LP and is one of the very few differences between the two investment vehicles. In other words, an owner could have the right to a greater amount of profits vs the amount that person contributed in capital, where in a LP situation, the profits are generally distributed in proportion to the amount of capital put into the partnership at its inception.
You might ask, well LP and LLC sound so similar, so what’s the difference for me?
Considering that the LLC was invented after Buffett formed his limited partnership, it may well be that he would’ve started an LLC instead of the partnership to manage those investments.
Much of the features are the same, and the difference between taxes and profits should be the biggest considerations– which makes the decision between an LP/LLC vs a corporation (Inc.) probably the more important decision instead of the secondary LP vs LLC.
Other Considerations Before Starting Your Investment Company
Before we sum up all of the lessons from this post into an actionable plan, there’s a few other important caveats to consider.
Keep in mind, these are just a few of the things I’ve come across as researching various options. There could be more, especially with how laws and regulations change all of the time. As they say, do your due diligence.
- Taking fees from investors
According to this article from the CFA institute, you will have to register as an RIA (registered investment advisor) with the SEC or your state if you plan to earn fees for managing other people’s money.
Keep in mind that this could also serve as an alternative to the LP vs LLC vs Incorporated structure that we’ve discussed here, or could also play a major factor in your final decision.
- Corporation types and PHC
If you do decide to go the corporation (inc) route, keep in mind that there are a variety of those types too, such as a C corporation and an S corporation. For the purposes of everything discussed in this article, the general functions of the corporation and its structure really refers to C Corporations.
And if the C corporation is the choice for your investment firm, you should also know about the Personal Holding Company, or PHC, rules.
Basically, PHC rules will generally outline the fees and taxes that are associated with starting and managing a corporation with the chief purpose of owning stocks. Warren Buffett’s Berkshire Hathaway is a holding company and has to abide by these rules as well.
The requirements behind the PHC are another topic on its own, but should definitely be researched in order to ensure compliance and that those align with your goals for the investment firm.
A great article by Upcounsel serves as a good start on the basics behind the PHC and should be required reading if you are going to incorporate.
Final Considerations: Starting an LLC for Investing or an Investment Partnership
You can see that there’s quite a few factors that play into the decision for what vehicle to use when starting an investment firm, and it really depends on your (and your investors’) end goals.
Some questions to ask yourself might be:
- What’s the long term goal of this investment firm?
- Would I (and the investors) want to take this firm public one day?
- Do investors need income now or are they wanting to defer?
- What’s the trading style I’ll be using?
- Does it lean towards more frequent or infrequent?
- What’s the intended ownership structure of this firm?
- Are we intending to bring on more investors in the future, or keep the owners mostly the same?
- What’s the trade-off here?
- Is the added complexity of an investment corporation worth the future flexibility?
- Do I prefer the simplicity of an LLC/LP instead?
I hope all of this helps, and is something to point you in the right direction as you navigate the options and concerns when starting an investment firm.
And if you’re looking for more ideas and lessons on analyzing stocks, researching companies and their annual reports, and making important portfolio management decisions and tracking return, this website is filled with articles like these, to help you do just that.
I wish the best of luck and success in your endeavors.
Remember, there’s a myriad of ways to make money with the stock market, so don’t get hung up on all the options. Just head down a direction and see what you find!