How to Invest Other People’s Money: Key Steps and Considerations

Managing investments for others comes with significant responsibilities, legal requirements, and ethical considerations. Whether starting a fund, managing assets professionally, or assisting friends and family, understanding the necessary steps is essential to avoid legal pitfalls and financial mismanagement.

Selecting the right business structure and ensuring regulatory compliance are key factors in success. Compensation arrangements and tax implications also shape both the adviser’s business and the client’s financial outcomes.

Required Credentials and Registration

In the United States, individuals or firms managing assets for compensation must comply with financial regulations designed to protect clients and maintain market integrity. Most investment advisers must register with either the Securities and Exchange Commission (SEC) or state regulators, depending on assets under management (AUM). The Investment Advisers Act of 1940 mandates SEC registration for firms managing over $100 million, while those below this threshold typically register with state securities authorities.

Registration requires filing Form ADV, which details business practices, fee structures, and potential conflicts of interest. This form is publicly accessible through the SEC’s Investment Adviser Public Disclosure (IAPD) database, allowing prospective clients to review an adviser’s background. Registered advisers must adhere to fiduciary duties, meaning they are legally required to act in their clients’ best interests, a higher standard than the suitability requirement imposed on broker-dealers.

Many investment professionals pursue certifications to enhance credibility. The Chartered Financial Analyst (CFA) designation, administered by the CFA Institute, is highly regarded for portfolio management and securities analysis. The Certified Financial Planner (CFP) credential, overseen by the CFP Board, is valuable for those providing comprehensive financial advice. Both require rigorous exams, work experience, and adherence to ethical standards.

Types of Business Structures

Choosing the right business structure affects liability, taxation, and regulatory requirements. Each option has advantages and drawbacks, depending on control, risk exposure, and administrative complexity.

General Partnerships

A general partnership (GP) is a business arrangement where two or more individuals share management responsibilities, profits, and liabilities. Unlike corporations or limited liability entities, general partners have unlimited personal liability, meaning their personal assets can be used to cover business debts or legal claims. Establishing a GP is relatively simple, often requiring only a partnership agreement outlining roles, responsibilities, and profit-sharing arrangements.

General partnerships are pass-through entities for tax purposes, meaning the business itself does not pay income tax. Instead, profits and losses are reported on each partner’s individual tax return using Schedule K-1 (Form 1065). Partners must also pay self-employment taxes, which include Social Security and Medicare contributions. While this structure offers flexibility, the lack of liability protection can be a significant drawback, especially when managing large sums of money.

Limited Partnerships

A limited partnership (LP) consists of at least one general partner who manages the business and assumes full liability, while limited partners contribute capital but have no management authority and limited liability. This structure is commonly used for investment funds, such as private equity or venture capital firms, where investors seek returns without direct involvement in decision-making.

Like general partnerships, LPs are pass-through entities for tax purposes, meaning income is reported on individual tax returns. Limited partners are not subject to self-employment taxes on their share of the profits, as they are considered passive investors under IRS rules. General partners, however, must pay self-employment taxes on their earnings. LPs must comply with state-specific regulations, including filing a certificate of limited partnership and adhering to reporting requirements. While this structure protects passive investors from liability, general partners remain personally exposed to financial and legal risks.

LLCs

A limited liability company (LLC) provides liability protection while offering tax flexibility, making it a popular choice for investment management businesses. Unlike general partnerships, LLC members are not personally liable for business debts, meaning their personal assets are generally protected.

For tax purposes, an LLC can be treated as a sole proprietorship (if single-member), a partnership (if multi-member), or elect to be taxed as an S corporation or C corporation. By default, multi-member LLCs are taxed as partnerships, with income passing through to members’ personal tax returns. However, LLC members may still be subject to self-employment taxes unless they elect S corporation taxation, which allows them to take a portion of earnings as distributions not subject to payroll taxes. While LLCs require more administrative work than partnerships, including filing articles of organization and maintaining operating agreements, they provide a strong combination of liability protection and tax efficiency.

Setting Payment Arrangements

Compensation structures for investment management impact revenue stability, tax treatment, and client expectations. Common approaches include asset-based fees, performance-based compensation, hourly rates, and fixed retainers, each with distinct financial and regulatory implications.

Asset-based fees, typically calculated as a percentage of AUM, are widely used in the investment advisory industry. A standard fee structure might range from 0.50% to 2% annually, often with tiered pricing where larger portfolios receive lower percentage fees. This model provides a predictable revenue stream and aligns the adviser’s interests with the client’s financial growth. However, it can also create conflicts, such as discouraging advisers from recommending cash withdrawals or lower-risk investments that could reduce AUM. Under SEC rules, advisers charging asset-based fees must disclose rates and potential conflicts in Form ADV.

Performance-based fees, often structured as a percentage of profits, are more common in hedge funds and private investment partnerships. A fund may charge a 2% management fee plus 20% of profits exceeding a benchmark return, known as the “2 and 20” model. While this structure incentivizes strong performance, it also encourages risk-taking, which is why the SEC imposes restrictions under Rule 205-3 of the Investment Advisers Act. Only clients classified as “qualified” under SEC guidelines—those with at least $1.1 million in net worth (excluding primary residence) or $2.2 million in AUM—can be charged performance-based fees. High-water marks and hurdle rates are often implemented to prevent advisers from earning fees on temporary gains or subpar returns.

Flat fees and hourly rates offer an alternative for clients who prefer predictable costs, particularly for financial planning or portfolio consulting services. A fixed retainer model, where clients pay a set monthly or annual fee, ensures compensation remains steady regardless of market fluctuations. Hourly billing, ranging from $150 to $500 per hour depending on expertise and location, is more suitable for one-time consultations rather than ongoing portfolio management. While these models avoid AUM-based conflicts, they may not be as scalable for advisers managing large client bases.

Client Qualifications

Selecting the right clients ensures alignment with an adviser’s investment strategy, risk tolerance, and operational capacity. Assessing prospective clients involves evaluating their financial situation, investment objectives, and level of sophistication.

Liquidity needs are a key consideration. Some investors require frequent access to their funds, while others can commit to long-term strategies. Managing capital for individuals who expect short-term liquidity might not be suitable for investment strategies focused on illiquid assets like private equity, real estate, or hedge funds.

Risk tolerance is another determining factor. Clients with low risk tolerance may not be suited for portfolios with high volatility, such as those heavily weighted in growth stocks, options, or leveraged instruments. Conducting in-depth risk assessments through questionnaires, stress tests, and historical performance simulations helps gauge a client’s comfort level with market fluctuations. Regulatory frameworks like FINRA Rule 2111 require advisers to consider factors such as age, income, and investment experience when making recommendations.

Relevant Tax Considerations

Tax implications affect both the investment manager and the clients. Proper tax planning ensures compliance with regulations while optimizing after-tax returns.

Investment income is taxed differently depending on its source. Capital gains, which arise from selling assets at a profit, are categorized as either short-term (held for one year or less) or long-term (held for more than a year). Short-term capital gains are taxed at ordinary income tax rates, while long-term capital gains benefit from lower rates. Dividend income is also subject to varying tax treatment, with qualified dividends taxed at long-term capital gains rates and non-qualified dividends taxed as ordinary income. Interest income from bonds, savings accounts, and other fixed-income investments is taxed at the investor’s marginal rate, though municipal bond interest is generally exempt from federal taxes.

Investment managers must also consider the tax treatment of their compensation. Asset-based fees and retainers are typically treated as ordinary business income, subject to self-employment taxes unless structured through an entity that provides payroll tax advantages. Performance-based fees, particularly those structured as carried interest in private equity or hedge funds, have historically been taxed at the lower long-term capital gains rate if held for at least three years, though ongoing legislative efforts seek to eliminate this benefit. Proper entity selection, such as electing S corporation status for an LLC, can help reduce self-employment tax liabilities by allowing a portion of income to be taken as distributions rather than salary.