Types of Clients and Customers

Types of Clients and Customers

The client's legal structure shapes everything: who has authority, what tax treatment applies, who bears liability, how decisions get documented, and what fiduciary duties the adviser owes. The Series 66 tests entity taxonomy and account titling heavily because misclassifying a client — or failing to recognize the duties owed to each — is a common source of regulatory violations. This chapter develops the major client types (individuals, joint accounts, business entities, trusts, estates, foundations, charities, custodial accounts), the trustee/fiduciary duties under the Uniform Prudent Investor Act, and the account-opening documentation requirements (KYC, CIP, beneficial ownership) under federal anti-money-laundering law.

Business Entities

• General Partnership: All partners share management and have unlimited liability. Income passes through to partners.
• Limited Partnership: General partners manage and have unlimited liability. Limited partners are passive investors with liability limited to their investment.
• Limited Liability Company (LLC): Combines limited liability protection with pass-through taxation. Flexible management structure.
• C-Corporation: Separate legal entity with double taxation — income taxed at corporate level and again when dividends distributed to shareholders.
• S-Corporation: Pass-through taxation (no double taxation), but limited to 100 shareholders and one class of stock.

Trusts, Estates, Foundations, and Charities

• Trusts: Legal entities that hold property for the benefit of designated beneficiaries. Managed by a trustee with fiduciary duties.
• Estates: Temporary entities created upon a person's death to manage and distribute assets according to the will or state law.
• Foundations: Typically have an endowment with specific spending requirements. Must distribute at least 5% of assets annually (private foundations).
• Charities: Tax-exempt organizations (501(c)(3)) with investment policies aligned to their charitable mission.

Individual clients — baseline taxonomy

Investment advisers serve different types of clients, each with unique legal, tax, and suitability considerations. The starting point is individual clients:

• Individuals and sole proprietors. Natural persons investing for personal goals (retirement, education, wealth building). Sole proprietors have no legal distinction between personal and business assets — they have UNLIMITED personal liability for business obligations.

Individual clients — what the adviser owes

Most adviser-client relationships begin with an INDIVIDUAL retail client. Several legal and practical features distinguish individual clients from entity clients:

• Capacity. The individual must have legal capacity to contract (typically age 18+, mentally competent). Power of attorney or guardianship arrangements transfer capacity when an individual cannot act.
• Suitability obligations. NASAA's model rule on suitability for individuals requires the adviser to document age, financial situation, tax status, investment objectives, time horizon, liquidity needs, risk tolerance, and investment experience BEFORE recommending any security.
• Privacy. Regulation S-P requires advisers to provide privacy notices and maintain confidentiality of nonpublic personal information. Sharing client data with third parties requires opt-out or opt-in consent depending on the relationship.
• Communication standards. Communications with individual retail clients are held to higher disclosure standards than with institutional clients. Fair and balanced presentation of risks is required for any recommendation.
• Senior clients. NASAA and FINRA both apply heightened suitability scrutiny for clients 65+ (or 60+ in some states) given vulnerability to undue influence and cognitive decline. Specific senior-fraud rules (NASAA Model Act on Vulnerable Adults) may apply.

Joint account types — how multiple owners hold property

When two or more individuals share an account, the LEGAL TITLE determines what happens on death, divorce, or creditor action. The major joint account types:

The single most-tested feature: JTWROS bypasses probate via automatic survivorship; TIC does NOT (deceased owner's share goes through estate). Series 66 favorite scenario: business partners hold a joint investment account — the suitable titling is TIC (each partner's heir gets the partner's share), not JTWROS (which would pass everything to the surviving partner regardless of will).

Custodial accounts for minors — UGMA, UTMA, and 529

Minors cannot legally hold securities accounts in their own name. Three vehicles allow gifts and investments for minors with adult management:

• UGMA (Uniform Gifts to Minors Act). Older statute, narrower scope. Allows gifts of cash, securities, and life insurance. Account titled "[custodian] as custodian for [minor] under UGMA." Custodian manages until minor reaches age of majority (typically 18 or 21); minor then receives all assets.
• UTMA (Uniform Transfers to Minors Act). Newer, broader scope. Allows transfers of ANY asset (including real estate, partnership interests, business interests). Most states have replaced UGMA with UTMA. Custodian and termination rules similar.
• 529 College Savings Plan. State-sponsored education savings vehicle. Contributions made with after-tax dollars; earnings grow tax-deferred; qualified education withdrawals (tuition, fees, room/board) are tax-free at the federal level. Owner retains control (unlike UGMA/UTMA); minor (or "designated beneficiary") doesn't have automatic claim.

Tax treatment: UGMA/UTMA earnings are taxed under "kiddie tax" rules — first ~$1,300 is tax-free, next ~$1,300 taxed at child's rate, anything above taxed at PARENT'S marginal rate (for children under 19, or full-time students under 24). 529 earnings are tax-deferred and tax-free if used for qualified education expenses.

Partnerships deeper — GP, LP, LLP, and the management trap

Partnership entities share a fundamental feature — pass-through taxation via Form 1065 and K-1s — but differ in liability allocation:

• General Partnership (GP). All partners have UNLIMITED personal liability for partnership debts. All partners may participate in management. Used historically for professional firms (law, accounting) before LLP availability.
• Limited Partnership (LP). At least one General Partner (UNLIMITED liability, manages business) and any number of Limited Partners (liability LIMITED to their investment, NO management participation). The LP form was historically used for real estate and oil/gas tax-shelter syndications.
• Limited Liability Partnership (LLP). All partners have limited liability for the firm's debts and other partners' malpractice, but retain personal liability for their OWN malpractice. Now standard for law firms, accounting firms, and architects.

Contrast: LLC members CAN actively manage without losing their liability protection (the LLC structure was specifically designed to solve the LP management trap). This is why most new closely-held businesses elect LLC over LP since the 1990s.

Corporations — C-corp vs. S-corp economic differences

Corporations are separate legal entities from their owners (shareholders). The choice between C-corp and S-corp is primarily a TAX election with significant economic consequences:

• C-Corporation. Default form. Pays corporate income tax (currently 21% federal flat rate). Dividends paid to shareholders are taxed AGAIN at qualified dividend rates (0/15/20%) for individuals. This is "double taxation." Used by all public companies and most large privately-held businesses. No restrictions on shareholder count or type.
• S-Corporation. Tax election (Form 2553). Income passes through to shareholders' individual returns via Form 1120-S and K-1s. NO corporate income tax. Restrictions: maximum 100 shareholders, only one class of stock, only US citizens/residents and certain trusts can be shareholders. Used by small-to-medium privately-held businesses.

The Series 66 doesn't require detailed corporate tax planning, but DOES test the structural distinction (double vs. pass-through), shareholder limits (100 for S-corp), and stock-class limits (one for S-corp).

Trust taxonomy deeper — major trust types tested

Beyond the revocable/irrevocable distinction, several specific trust types appear on the Series 66:

• Living trust (inter vivos). Created during the grantor's lifetime. Can be revocable or irrevocable.
• Testamentary trust. Created at grantor's death via will. Goes through probate (since the will does). Common for trusts benefiting minor children where parents want gradual distribution.
• Bypass / Credit Shelter Trust. Funded at first spouse's death to use the deceased's federal estate tax exemption. Assets bypass the surviving spouse's estate, preserving the exemption. Heavily used pre-2010 portability; less common now but still tested.
• Marital / QTIP Trust. "Qualified Terminable Interest Property" trust. Surviving spouse receives income for life; principal distributes to specified beneficiaries (often deceased's children from prior marriage) at surviving spouse's death. Common in blended families.
• Irrevocable Life Insurance Trust (ILIT). Owns life insurance on the grantor; proceeds at death pass to beneficiaries WITHOUT inclusion in the grantor's estate (removing the death benefit from estate tax). Funded by gifts (often within annual exclusion).
• Special Needs Trust (SNT). Holds assets for a disabled beneficiary without disqualifying them from means-tested government benefits (SSI, Medicaid). Strict distribution rules.
• Charitable Remainder Trust (CRT). Grantor (or named beneficiary) receives income for a term of years or life; remainder passes to charity. Provides current charitable deduction and removes assets from estate.
• Charitable Lead Trust (CLT). CHARITY receives income for a term; remainder passes back to grantor's family. Opposite economic split from CRT.

Trustee duties — the Uniform Prudent Investor Act (UPIA)

Trustees owe fiduciary duties to beneficiaries that are FAR more stringent than the duties an adviser owes to an ordinary brokerage customer. The Uniform Prudent Investor Act (UPIA), adopted by most states, codifies these duties:

• Duty of loyalty. The trustee must act SOLELY in the interests of the beneficiaries. Self-dealing (transactions benefiting the trustee personally) is prohibited absent specific authorization.
• Duty of impartiality. When multiple beneficiaries have different interests (e.g., income beneficiary vs. remainder beneficiary), the trustee must balance their interests fairly — not favor one over the other.
• Prudent investor standard. Investment decisions evaluated in the context of the OVERALL PORTFOLIO (modern portfolio theory), not security-by-security. Diversification is required unless special circumstances justify concentration.
• Duty to delegate prudently. Trustees CAN delegate investment management to professional advisers but must do so carefully (selecting competent advisers, setting clear scope, monitoring performance). Delegation doesn't eliminate trustee responsibility.
• Duty to account. Trustees must provide regular accountings to beneficiaries showing receipts, disbursements, and current asset values.
• Cost-conscious investing. Trustees must control investment expenses to the extent they're appropriate — high-cost investments require justification.

The duty of impartiality has specific application to income vs. principal: trustees often must produce both INCOME (for current income beneficiaries) AND GROWTH (for remainder beneficiaries). This typically means balanced portfolios with both bonds (income) and stocks (growth). A trustee invested 100% in bonds would underserve remainder beneficiaries; 100% in stocks would underserve income beneficiaries. The Series 66 tests recognition of this dual-mandate balancing.

Grantor trust rules — when the trust is treated as the grantor

Under IRC §671-679, certain trust structures cause the trust's INCOME to be taxed to the GRANTOR (creator) rather than the trust itself or beneficiaries. The trust is then called a "grantor trust" for income tax purposes:

• Revocable trusts are ALWAYS grantor trusts during the grantor's lifetime — the grantor can take the assets back, so the IRS treats them as the grantor's.
• Reversionary interests exceeding 5% of trust value at the time of transfer trigger grantor-trust status.
• Power to control beneficial enjoyment (grantor can change beneficiaries or alter distributions) triggers grantor-trust status.
• Administrative powers like the power to vote stock, borrow without adequate interest, or substitute trust property may trigger grantor-trust status.
• Power to receive income or have it used to pay grantor's expenses (premiums on life insurance, etc.) triggers grantor-trust status.

The Series 66 expects you to recognize that revocable living trusts are grantor trusts (and offer NO income tax benefit) while irrevocable trusts MAY or may NOT be grantor trusts depending on structure. The misconception that "irrevocable = separate taxpayer" is common but incorrect — the grantor trust rules can apply to irrevocable trusts.

Foundations vs. public charities — the key distinctions

All foundations and public charities are 501(c)(3) tax-exempt organizations, but they differ significantly in regulatory treatment and donor benefits:

The 5% rule for foundations drives investment policy. Foundation portfolios must generate enough return to cover the 5% distribution AND inflation (typically 2-3%) AND fees (0.5-1%) — meaning real returns of 8-9% needed to sustain real spending. This pushes foundations toward higher-returning, more volatile portfolios than public charity endowments.

Donor-advised funds and endowments

Donor-Advised Funds (DAFs). Donors contribute to a sponsoring public charity (Fidelity Charitable, Schwab Charitable, Vanguard Charitable, community foundations) and receive an immediate charitable deduction. The donor then "advises" (recommends) which charities receive grants from the fund over time. Key features:

• Immediate deduction at contribution, with grant timing flexibility over many years.
• Public-charity tax treatment (60% AGI deduction limit for cash, 30% for appreciated assets).
• No 5% annual distribution requirement (unlike private foundations).
• Anonymity available — grants can be made anonymously to recipient charities.
• Investment options — sponsoring charity offers a menu of investment pools; donor selects allocation.
• Lower setup cost than a private foundation (no minimum, no separate legal entity required).

Endowments. Funds held by educational, religious, or cultural institutions as permanent capital, with spending policy designed to preserve real value across generations. Typical features:

• Spending policy typically 4-5% of trailing 3-year average market value annually.
• Long horizon and risk tolerance — major university endowments (Harvard, Yale, Stanford) hold 40-70% in alternatives (private equity, hedge funds, real assets).
• Investment policy committee oversight required by best practice and (in some states) statute.
• UPMIFA (Uniform Prudent Management of Institutional Funds Act) governs endowment management in most states — similar to UPIA for trusts.

Account opening requirements — documentation framework

Federal and state law impose specific information-collection requirements before an adviser can open an account. The framework involves several overlapping rules:

• Form ADV Part 2. Brochure delivery to clients at or before contract signing.
• Investment advisory agreement. Written contract specifying scope, fees, term, termination, and disclosures.
• Suitability information. Age, financial situation, investment objectives, time horizon, liquidity needs, risk tolerance, tax status, investment experience.
• Customer Identification Program (CIP). Verify client identity per USA PATRIOT Act / Bank Secrecy Act. Must collect: name, date of birth, address, taxpayer ID. Verify through documents (driver's license, passport) or non-documentary methods.
• Anti-Money-Laundering (AML) screening. Check the OFAC Specially Designated Nationals list, screen for politically exposed persons (PEPs), evaluate source of funds for high-risk clients.
• Beneficial ownership (Reg CDD). For legal entity accounts (LLCs, corps, partnerships), collect identifying information for each individual owning 25%+ of the entity AND for one control person (CEO, managing partner, etc.).
• Privacy notice (Reg S-P). Provide privacy notice at account opening and annually thereafter.
• Trusted contact person. For senior clients (and as best practice for all), request authorization to contact a designated person if the adviser suspects diminished capacity, exploitation, or fraud.

Know Your Customer (KYC) and CIP — the AML framework

The USA PATRIOT Act (2001) and the Bank Secrecy Act establish a federal anti-money-laundering framework that broker-dealers and investment advisers must follow. Three overlapping concepts:

• Customer Identification Program (CIP). The MECHANICAL requirement — verify identity at account opening through documents or non-documentary methods. Cannot open the account without satisfying CIP.
• Know Your Customer (KYC). The broader OBLIGATION — understand the customer, their business, the source of their funds, and their expected account activity. Used to detect anomalies (large unusual transactions, structuring to avoid reporting thresholds).
• Customer Due Diligence (CDD) / Beneficial Ownership (Reg CDD). For LEGAL ENTITY customers (LLCs, corps, partnerships), collect ownership and control information for individuals owning 25%+ AND for one control person. Designed to prevent anonymous shell companies from accessing the financial system.

Reporting obligations under the AML framework:

• Currency Transaction Reports (CTR). Required for cash transactions over $10,000 (single transaction or aggregated daily).
• Suspicious Activity Reports (SAR). Required when a transaction is suspicious (no apparent business purpose, structuring, dealing with high-risk countries). Filed confidentially with FinCEN — the firm CANNOT tell the customer that a SAR was filed ("tipping off" is a federal crime).
• FBAR filing. Clients with foreign accounts exceeding $10,000 must file FinCEN Form 114. Advisers should ensure clients understand this obligation.

Discretionary authority, trading authorization, and POA

Sometimes the adviser or another person needs authority to trade on the client's behalf. Several frameworks exist:

• Discretionary investment authority. Granted to an investment adviser as part of the advisory agreement. Allows the adviser to make securities decisions WITHOUT pre-approval for each trade. Requires written authorization in the advisory contract. Standard for fee-based advisory accounts.
• Limited trading authorization. Granted to a third party (typically the adviser) to trade securities without taking custody. The third party can buy/sell securities but cannot withdraw funds from the account.
• Full trading authorization (POA). Power of Attorney granted to a third party allowing them to trade AND withdraw funds/securities. Constitutes CUSTODY under the Custody Rule if held by the adviser — triggers surprise audit requirements.
• Durable power of attorney. POA that REMAINS valid if the principal (account owner) becomes incapacitated. Standard estate-planning document, often broader than financial-only POAs.
• Springing power of attorney. POA that becomes effective ONLY upon a triggering event (typically certification of incapacity by a physician). Avoids granting authority before it's needed.

Entity tax treatment — complete comparison

Revocable vs. irrevocable trust — comparison