An escape from the retirement dilemma
Solving the Problem of the Unfunded Exit Strategy
A key question facing every CPA is "How will my firm handle my buyout when I retire?" The recent consolidations of accounting firms have brought the problem of unfunded retirement liabilities into the limelight, but selling out to a consolidator does not have to be the only secure way to fund a retirement. The purpose of this article is to address the retirement dilemma. The author presents a tax-efficient alternative to the traditional model for dealing with this issue.
The retirement dilemma is not a new problem, nor is it simply an issue facing retiring CPAs: Younger professionals must address how they are going to compensate their mentors for the practice they will inherit-without exposing themselves to a large liability in this rapidly changing era. Naturally, the retiring owner is worried about the firm's ability to pay him for the value of his interest in the firm over time. Furthermore, because these payments are subject to the firm's creditors, the retiring owner is anxious for the firm to continue to prosper so that postretirement plans will be secure.
Nonretiring owners are concerned about the exact same things as retiring owners-from the opposite perspective. They worry whether they will be able to retain the clients developed by the retiree, whether they can steer the firm in a rapidly changing business environment, and whether their firm will be able to compete with the new practice structures. This can lead to serious concerns regarding their firm's ability to pay an increasingly large unfunded liability as more owners retire. They fear that the net effect of business pressures and the committed payments to retirees will reduce cash flows to the detriment of their lifestyles.
In addition, if a retiring partner continues to receive income from the firm and accepts employment with an attest client, the firm's independence will be impaired, jeopardizing revenues. Furthermore, these problems are often addressed too late to craft a solution that comfortably satisfies the concerns of all the parties. The lack of a properly structured exit strategy, implemented in a timely fashion, often forces a firm that would never have considered selling its practice to face the unpleasant trade-off of autonomy for near-term cash needs to honor commitments to retirees.
Traditional Planning Models
Exit strategies are generally designed to deal with the following contingencies:
The traditional methods of funding retirement obligations and life and disability insurance payments create tax inefficiencies and significant risks. Buyout payments to retiring owners are nondeductible to the firm or successor principals. Moreover, the retiree is subject to capital gains taxes on the payments and any residual value is subject to estate taxes when assets transfer to the next generation. Life and disability insurance premiums are typically paid with after-tax dollars, creating additional costs to the firm, which does not receive the benefit of a tax deduction for the payments.
Due to these tax inefficiencies, most firms utilize some form of nonqualified deferred compensation plan to provide the promised benefits to retiring owners. In effect, the firm converts most of its previously nondeductible obligation into tax-deductible payments that are also taxed as ordinary income to the retiring partner. Funded or unfunded arrangements are typically chosen to cover retirement benefits, whereas insurance is usually chosen to cover disability and death benefits. The retirement benefits, funded or unfunded, are almost always provided for in nonqualified plans, with provisions set forth in the firm's partnership agreement (or a separate agreement if the firm operates as a corporation). All benefits of unfunded arrangements are financed with the postretirement earnings of the firm. …