John was one of three founding partners in a firm formed 35 years ago. He oversaw the buyout of the other two founding partners and, as managing partner, groomed three young managers as his successors. However, when the time came for these managers to be admitted as partners, two of them declined, citing their reluctance to take on John’s buyout. Show What went wrong? The terms of the partnership agreement would have required the firm’s new partners to either infuse capital into the firm or take a significant reduction in compensation over the next five years to fund John’s buyout. Both managers felt they could find a better opportunity at another firm. John and his remaining partner were forced to find another firm to merge into, and John’s retirement payments ended up being a lot lower than he had planned. How could John and the firm have avoided this result? ASSESSING AN INTERNAL BUYOUT PLAN’S FINANCIAL VIABILITY This goal is the reason some firms are moving toward partially prefunded plans. However, the overwhelming tendency remains not to prefund owner retirement. The AICPA’s 2008 PCPS Succession Survey found that 79% of firms did not fund owner retirement and that another 7% funded 20% or less of the retirement. The primary capital a firm has available for funding buyouts and retirements is the departing owner’s foregone compensation. Compensation has to be used for three things for the plan to be considered self-funding. Those are:
The expectation that the firm’s owner retirement plan is not viable is the biggest reason we see that firms seek third-party sales and mergers—to avoid taking on internal buyout obligations. This concept can be demonstrated by two case studies. CASE STUDY 1 The firm’s remaining owners believe they would be able to assume her duties for managing client relationships as well as other key duties. However, to replace her productive capacity ($350,000 of billable time), the firm would have to hire additional personnel at an annual cost of $140,000 including benefits. Using the $270,000 of compensation as the available funds, there would be $130,000 of cash flow remaining after the cost of replacement resources. The additional capital the firm would have to invest in the first year to make this plan work is $225,000 (including $175,000 to pay out the capital account) and $50,000 per year for the next four years (see Exhibit 1).
 Because the funds available from the retired owner’s foregone compensation are inadequate to cover the required payments, the plan is not self-funding and may not be viable as a result. To make the plan self-funding, this firm should consider:
The Premise of Worth in an Accounting Firm Issues usually arise with intangible assets. Intangible assets comprise what is often referred to as “blue sky,” which includes goodwill, workforce in place, and brand names, as well as, potentially, other intangible items. It is not unusual for intangible assets to be two to five times the value of tangible assets. Blue sky is based on the future earnings capability of the business. In most accounting firms, the biggest factor affecting future earnings is retention of clients and staff following a change in control, whether that is due to an owner’s retirement or a sale. CASE STUDY 2 The annual payments to him for the “intangible value” (see sidebar, “The Premise of Worth in an Accounting Firm”) portion of the buyout would be $96,250 per year for 10 years, and the payout of his capital would be approximately $45,000 per year for five years. The cash flow for this plan would be as shown in Exhibit 3. The plan is self-funding for all the years of the payout because the retiring partner’s foregone compensation covers all of the firm’s obligations.
Another key element that assists in making an agreement financially viable is instituting a cap on the amount of payments that can be made to all retiring owners at one time. The cap is often expressed as a percentage of revenues, although profit before owner compensation is also used. In large firms, this number can be as low as 3% of revenues; in smaller firms, this number can grow to as high as 20%. The usual rate is 6% to 8%. The purpose of this provision is to ensure that the firm remains a viable debtor in the event of a decrease in profits. Usually, any retirement payments prevented by the cap are not relinquished permanently but rather deferred to a later period, when the threshold is not exceeded. This kind of protection is mutually beneficial for the firm and its retired owners. Firms that are burdened with more retirement debt than the current owners can handle might be unable to retain the owners necessary to keep the firm healthy enough to satisfy those debts. CONCLUSION
External vs. Internal Transactions - An external sale often emerges from a bidding process that may include several potential buyers; an internal succession involves one potential buyer and no negotiation at the closing of the transaction, if it is governed by a pre-existing agreement. - An internal “sale” usually is, in effect, a put option granted to the seller. The firm or its owners are contractually obligated to make the acquisition. Therefore, it is justifiable that there be a cost for the right to “put” the interest, which is often reflected as a discount in the pricing of the firm or a variance in the terms compared with an external deal. For example, given the choice between (1) looking for a buyer for an equity position with no certainty of what would be available in the market or (2) having the opportunity to exercise an option to sell at a predetermined price to a buyer compelled to make the purchase, most sellers would elect the latter. A buyer would likely expect to pay less and on different terms in exchange for assuming that obligation. - The package of terms for an internal deal often are dramatically different from those for a third-party sale. For instance, it is rare that the terms for a pure acquisition include (1) setting the price at closing and (2) a payment period of 10 or more years. It is common for those terms to be the basis for an internal transaction. - Clients and staff are not being asked to change firms in an internal transition as they are in a third-party sale and, therefore, there is a higher probability of retention in an internal transition. - In firms that have unbalanced ownership, a retiring owner can sometimes have a disproportionate stake in the firm. Sometimes, that ownership does not reflect the value that has been created by the remaining owners who will be responsible for the buyout. For example, Sue owns 60% of the equity in her four-partner firm. She is in that position because she is the longest-serving partner, and equity for retired partners always was redistributed pro rata to existing equity holdings. The reality is that Sue manages less than 25% of the firm’s business, and her compensation is less than 25% of overall partner compensation. Paying her for her equity based on 60% of the firm’s overall value, as defined by the terms of the agreement, may be unrealistic for the other partners. As a result of the above factors, the normal range of multiples is often lower in internal buyouts and retirements than in third-party sales. In the work we do with accounting firms nationally, we routinely see pricing for internal purposes of between 50% and 100% of revenues for equity-based plans and between two times and three times annual compensation for plans based on owner compensation. The trend, based on our work with hundreds of firms, is a decrease in pricing multiples as firms prepare themselves for an unprecedented increase in baby boomer retirements. (This mirrors the downward trend in external transactions, where pricing can vary widely based on the market, firm size, client mix and other factors.) Ten years ago, internal pricing of less than 100% of revenues or three times compensation was much less common. According to the AICPA’s 2008 PCPS Succession Survey, 42% of firms using a revenue multiplier for internal valuations used 100% as the metric, and 7% used a higher multiplier. About 38% of firms using a compensation multiplier used three times annual compensation, and 8% used a higher multiplier. Effect of Tax Treatment and Interest on Deferred Payments in Buyout Terms Retirement payments usually are deductible by the firm as compensation, and they are taxed as ordinary income to the retiring partner. However, there is an increasing trend in the profession to treat at least a portion of buyout payments to retired partners as for the acquisition of goodwill or another asset amortizable for tax purposes under Sec. 197. This allows the retiring partner to treat the portion of the payment that is attributable to the goodwill buyout as capital gain, taxable at lower rates than ordinary income. But this treatment means that the firm cannot deduct that portion of the payments immediately; instead, it must be amortized over 15 years under Sec. 197. This increases the cost of the buyout to the firm. For this reason, the most common approach remains treating internal buyouts as retirement payments or, for firms that wish to find a more desirable tax treatment for retired owners, stretching the payout period to 10 years or longer so the payments can be treated in a manner that gives the retired owner capital gains treatment without creating an unacceptable cost to the firm. Notice
Required for Retirement In the event adequate notice is not given, the preferable consequence is to subject the buyout payments to adjustment for the firm’s loss of business during the two years following the owner’s exit under the premise such diminishment of value was due to the lack of time to adequately transition the retiring partner’s duties and relationships. Example. A partner leaves the firm without giving the notice the partnership agreement requires. During the subsequent two years, the firm loses 10% of its
business. The partnership agreement could require a 10% reduction in that partner’s buyout payments. The agreement could require measuring the “lost business” on a firm-wide basis or restrict the measurement to the portion of the business the departing partner was responsible for managing. EXECUTIVE SUMMARY Joel Sinkin ( ) is president, and Terrence Putney ( ) is CEO, both of Transition Advisors LLC. AICPA RESOURCES JofA articles
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What are the different methods to pay the retiring partner?Four methods of payment to retiring partner. Lump sum payment of the amount (paid immediately). Transfer of amount due, to his loan account.. Part payment of the claim.. Payment of retiring partner's loan by annual installments.. How is the account of retiring partner settled?Solution. The amount due to a retiring partner is settled as per the terms of partnership agreement or otherwise mutually agreed upon either in lumpsum or in instalments.
How do you close retiring partners capital account?(iii) The retiring partner's capital account is debited with his/her share of goodwill and remaining partner's capital account is credited in their gaining ratio. (iv) In case goodwill account is written off the capital account of all partners is credited. (ii) For decrease in value of assets: Revaluation A/c Dr.
Which of the following can be the mode of settlement of retiring partner?Lump-Sum payment: Other partners may settle the retiring partner by an immediate lump sum payment. Transfer of the amount due, to his loan account: Other partners may agree on adjusting the retiring payment amount to his loan account.
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