Academic journal article Journal of Accountancy

Planning and Paying for Partner Retirements: Structure Internal Succession Agreements to Make Buyouts Self-Funding

Academic journal article Journal of Accountancy

Planning and Paying for Partner Retirements: Structure Internal Succession Agreements to Make Buyouts Self-Funding

Article excerpt

EXECUTIVE SUMMARY

* The vast majority of CPA firms do not prefund partner retirement plans, resulting in internal successor partners' bearing the responsibility for funding retirement from the firm's future cash flow.

* When structuring a retirement strategy or internal buyout, the No. 1 goal is to ensure the plan is self-funding. A self-funding plan must replace the retired owner, pay for the buyout/retirement and produce benefits for the remaining partners so they are motivated to do the deal.

* Buyout or retirement plans that aren't self-funding tan result in loss of business, the need to pump capital into the firm and the remaining partners' having to work harder for the same or declining compensation. Even the threat of that happening can kill an internal buyout or retirement plan.

* The main source for funding buyout or retirement plans is the compensation the firm no longer has to pay the departing partner,

* Strategies to make a plan self-funding include reducing the revenue multiple used to determine the buyout price and increasing the number of years over which retirement and capital account payments are made.

* Firms facing the retirement of multiple partners can institute a cap on the amount of payments that can be made to all owners. This helps keep the firm financially viable if there is a drop in profits. The cap usually is a percentage of revenues ranging from 3% to 20%, and payments to the retired partners generally are deferred until the firm has the funds available.

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[ILLUSTRATION OMITTED]

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.

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

External and internal sales of accounting firms have significant differences (see sidebar, "External vs. Internal Transactions"). The most important objective in structuring an internal buyout or retirement plan is to make it self-funding. 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 round 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:

* Replacing the retired owner;

* Paying for the buyout/retirement; and

* Creating some upside for the remaining owners to motivate them to take on the obligations created by the buyout.

A failure to meet all three objectives can lead to: (1) loss of business, (2) the necessity to infuse capital from external sources such as borrowed funds or contributed capital, and (3) the remaining owners' working harder for no additional, or even decreasing, compensation. Even the perception that this might be the outcome of a buyout plan can sink the deal if the owners who would be required to take on the obligation decide their future prospects are not desirable. …

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