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P R A C T I C E M A N A G E M E N T

Planning and Paying for

Partner RetirementsStructure internal succession agreementsto make buyouts self- funding.

by Joel Sinkin and Terrence Putney, CPA

Partner Retirements_Sinkin_Apr12_JOA 3/4/12 4:01 PM

What went wrong? The terms of the part-nership agreement would have requiredthe firm’s new partners to either infuse cap-ital into the firm or take a significant re-duction in compensation over the next fiveyears to fund John’s buyout. Both managersfelt they could find a better opportunity at

another firm. John andhis remaining partner

were forced to find

another firm to merge into, and John’s re-tirement payments ended up being a lotlower than he had planned. How couldJohn and the firm have avoided this result?

ASSESSING AN INTERNALBUYOUT PLAN’S FINANCIALVIABILITYExternal and internal sales of accounting

firms have significant differences (seesidebar, “External vs. Inter-

nal Transactions”). Themost important objectivein structuring an internal

buyout or retirement planis to make it self-funding.

This goal is the reason some firms are mov-ing toward partially prefunded plans. How-ever, the overwhelming tendency remainsnot to prefund owner retirement. TheAICPA’s 2008 PCPS Succession Survey foundthat 79% of firms did not fund owner re-tirement and that another 7% funded 20%or less of the retirement.

The primary capital a firm has availablefor funding buyouts and retirements is thedeparting owner’s foregone compensation.Compensation has to be used for threethings 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 remain-

ing owners to motivate them to take onthe obligations created by the buyout.A failure to meet all three objectives can

lead to: (1) loss of business, (2) the neces-sity to infuse capital from external sourcessuch as borrowed funds or contributedcapital, and (3) the remaining owners’


ohn was one of three founding partners in a firm formed 35 yearsago. He oversaw the buyout of the other two founding partnersand, as managing partner, groomed three young managers as his

successors. However, when the time came for these managers to be ad-mitted as partners, two of them declined, citing their reluctance to takeon John’s buyout.

J


30 Journal of Accountancy April 2012 www.journalofaccountancy.com

working harder for no additional, or evendecreasing, compensation. Even the per-ception that this might be the outcome ofa buyout plan can sink the deal if the own-ers who would be required to take on theobligation decide their future prospects arenot desirable.

The expectation that the firm’s ownerretirement plan is not viable is the biggestreason we see that firms seek third-partysales and mergers—to avoid taking on in-ternal buyout obligations. This conceptcan be demonstrated by two case studies.

CASE STUDY 1Firm A has five owners. One owner is re-tiring in two years. She earns $270,000 peryear and owns 30% of the $3 million firm.Her retirement is based on her ownershippercentage multiplied by the firm’s annualfees billed for the 12 months preceding herretirement, which would be $900,000 (or30% of $3 million). This total is to be paidover five years without interest, a total of$180,000 per year. In addition, she wouldbe paid the full amount of her accrual-basiscapital account, which is $175,000 at thedate of her retirement. This owner gener-ates 1,400 billable hours per year at an av-erage billing rate of $250 per hour.

The firm’s remaining owners believethey would be able to assume her duties formanaging client relationships as well asother key duties. However, to replace herproductive capacity ($350,000 of billable


E X E C U T I V E S U M M A R Y

■ The vast majority of CPAfirms do not prefund partnerretirement plans, resulting in internal successor partners’ bear-ing the responsibility for fundingretirement from the firm’s futurecash flow. ■ When structuring a retire-ment strategy or internal buy-out, the No. 1 goal is to ensurethe plan is self-funding. A self-funding plan must replace the retired owner, pay for the buy-out/retirement and produce ben-

efits for the remaining partners sothey are motivated to do the deal. ■ Buyout or retirement plansthat aren’t self-funding can result in loss of business, theneed to pump capital into the firmand the remaining partners’ havingto work harder for the same or declining compensation. Even thethreat of that happening can kill aninternal buyout or retirement plan. ■ The main source for fundingbuyout or retirement plans isthe compensation the firm no

longer has to pay the departingpartner. ■ Strategies to make a planself-funding include reducingthe revenue multiple used to determine the buyout price andincreasing the number of yearsover which retirement and capitalaccount payments are made. ■ Firms facing the retirementof multiple partners can insti-tute a cap on the amount ofpayments that can be made toall owners. This helps keep the

firm financially viable if there is adrop in profits. The cap usually isa percentage of revenues rang-ing from 3% to 20%, and pay-ments to the retired partnersgenerally are deferred until thefirm has the funds available.

Joel Sinkin (jsinkin@transition

advisors.com) is president, and

Terrence Putney (tputney@

transitionadvisors.com) is CEO,

both of Transition Advisors LLC.

Exhibit 1 5-Year Payout at 100%; CapitalFully Paid in Year 1

Year 1 Years 2–5Available funds $ 270,000 $270,000Payout of capital account (175,000) N/ARetirement payments (180,000) (180,000)Replacement resources (140,000) (140,000)Annual shortfall $(225,000) $ (50,000)

Exhibit 2 10-Year Payout at 80%; CapitalPaid Over Five Years

Year 1 Years 2–5 Years 6–10Available funds $270,000 $270,000 $270,000Payout of capital account (35,000) (35,000) N/ARetirement payments (72,000) (72,000) (72,000)Replacement resources (140,000) (140,000) (140,000)Annual surplus $ 23,000 $ 23,000 $ 58,000

Exhibit 3 10-Year Payout; Capital Paid OverFive Years at Prime Rate

Years 1–5 Years 6–10Available funds $350,000 $350,000Payout of capital account (45,000) N/ARetirement payments (96,250) (96,250)Replacement resources (140,000) (140,000)Annual surplus $ 68,750 $113,750


time), the firm would have to hire addi-tional personnel at an annual cost of$140,000 including benefits.

Using the $270,000 of compensationas the available funds, there would be$130,000 of cash flow remaining after thecost of replacement resources. The addi-tional capital the firm would have to in-vest in the first year to make this plan workis $225,000 (including $175,000 to payout the capital account) and $50,000 peryear for the next four years (see Exhibit 1).

Because the funds available from the re-tired owner’s foregone compensation are

inadequate to cover the required payments,the plan is not self-funding and may not beviable as a result.

To make the plan self-funding, this firmshould consider:■ Reducing the valuation multiple of trail-

ing revenues from 100% to a lower mul-tiple (see sidebar, “The Premise of Worthin an Accounting Firm”);

■ Extending the payment period for theretirement payments to more than fiveyears; or

■ Stretching the payment period for thecapital account.

If the multiple for retirement paymentswere decreased to 80% from 100%, thepayout period for the retirement paymentswere increased to 10 years from five years,and the capital account were paid over fiveyears instead of one year, the cash flow forthe firm would be as shown in Exhibit 2.This approach is self-funding and, as a re-sult, more viable.

CASE STUDY 2Firm B has six owners. The firm pays re-tirement over 10 years based on 2.75times the average of the past five years’

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Many firms, when setting terms in a buy-sell or partnershipagreement, refer to what they believe they could obtain if athird party bought the firm. However, some significant dif-ferences between the two types of transactions should beconsidered. These include:

■ An external sale often emerges from a bidding processthat may include several potential buyers; an internal suc-cession involves one potential buyer and no negotiation atthe closing of the transaction, if it is governed by a pre-exist-ing agreement.

■ An internal “sale” usually is, in effect, a put optiongranted to the seller. The firm or its owners are contractuallyobligated to make the acquisition. Therefore, it is justifiablethat there be a cost for the right to “put” the interest, whichis often reflected as a discount in the pricing of the firm or avariance in the terms compared with an external deal. Forexample, given the choice between (1) looking for a buyerfor an equity position with no certainty of what would beavailable in the market or (2) having the opportunity to ex-ercise an option to sell at a predetermined price to a buyercompelled to make the purchase, most sellers would electthe latter. A buyer would likely expect to pay less and ondifferent terms in exchange for assuming that obligation.

■ The package of terms for an internal deal often aredramatically different from those for a third-party sale. Forinstance, it is rare that the terms for a pure acquisition in-clude (1) setting the price at closing and (2) a payment peri-od of 10 or more years. It is common for those terms to bethe basis for an internal transaction.

■ Clients and staff are not being asked to change firms inan internal transition as they are in a third-party sale and,therefore, there is a higher probability of retention in an in-ternal transition.

■ In firms that have unbalanced ownership, a retiring

owner can sometimes have a disproportionate stake in thefirm. Sometimes, that ownership does not reflect the valuethat has been created by the remaining owners who will beresponsible for the buyout. For example, Sue owns 60% ofthe equity in her four-partner firm. She is in that positionbecause she is the longest-serving partner, and equity for re-tired partners always was redistributed pro rata to existingequity holdings. The reality is that Sue manages less than25% of the firm’s business, and her compensation is lessthan 25% of overall partner compensation. Paying her forher equity based on 60% of the firm’s overall value, as de-fined by the terms of the agreement, may be unrealistic forthe other partners.

As a result of the above factors, the normal range of mul-tiples is often lower in internal buyouts and retirementsthan in third-party sales. In the work we do with accountingfirms nationally, we routinely see pricing for internal pur-poses of between 50% and 100% of revenues for equity-based plans and between two times and three times annualcompensation for plans based on owner compensation. Thetrend, based on our work with hundreds of firms, is a de-crease in pricing multiples as firms prepare themselves foran unprecedented increase in baby boomer retirements.(This mirrors the downward trend in external transactions,where pricing can vary widely based on the market, firmsize, client mix and other factors.)

Ten years ago, internal pricing of less than 100% of rev-enues 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 valuationsused 100% as the metric, and 7% used a higher multiplier.About 38% of firms using a compensation multiplier usedthree times annual compensation, and 8% used a highermultiplier.

External vs. Internal Transactions


32 Journal of Accountancy April 2012 www.journalofaccountancy.com

compensation, eliminating the low andhigh of those years. Capital is paid outover five years with interest at The WallStreet Journal prime rate (as of this writ-ing, 3.25%). One owner is retiring in twoyears. His average compensation for cal-culation of retirement is $350,000, andhis capital account is $210,000. Based onhis productivity, the firm believes it can re-place him for about $140,000 per year.

The annual payments to him for the“intangible value” (see sidebar, “The Prem-ise of Worth in an Accounting Firm”) por-tion of the buyout would be $96,250 peryear for 10 years, and the payout of hiscapital would be approximately $45,000

per year for five years. The cash flow forthis plan would be as shown in Exhibit 3.

The plan is self-funding for all the yearsof the payout because the retiring partner’sforegone compensation covers all of thefirm’s obligations.

Another key element that assists inmaking an agreement financially viable isinstituting a cap on the amount of pay-ments that can be made to all retiring own-ers at one time. The cap is often expressedas a percentage of revenues, although prof-it before owner compensation is also used.In large firms, this number can be as lowas 3% of revenues; in smaller firms, thisnumber can grow to as high as 20%. Theusual rate is 6% to 8%.

The purpose of this provision is to en-sure that the firm remains a viable debtorin the event of a decrease in profits. Usual-ly, any retirement payments prevented bythe cap are not relinquished permanently

but rather deferred to a later period, whenthe threshold is not exceeded. This kind ofprotection is mutually beneficial for the firmand its retired owners. Firms that are bur-dened with more retirement debt than thecurrent owners can handle might be unableto retain the owners necessary to keep thefirm healthy enough to satisfy those debts.

CONCLUSIONThere is much more to managing suc-cession for an accounting firm’s ownersthan just the buyout’s financial terms.Certainly, developing a strong team ofprofessionals who can replace retiringowners is paramount and is an area inwhich many firms fall short. A financialplan that creates a reasonable obligationfor the firm and its remaining ownersis key to ensuring long-term stability.Owner agreements governing retirementand other forms of buyout payments


Effect of Tax Treatment and Interest on DeferredPayments in Buyout TermsAssume the benchmark for a pricing multiple in a firm sale is one times revenuesand the payments are tax neutral to the buyer, meaning they can be deducted aspaid. If the total obligation is $1 million and the payments are made over 10years, the firm would pay a retired owner $100,000 per year. However, if the firmis required to pay 6% annual interest on the deferred payments, the total obliga-tion increases to $1,332,246 (assuming monthly payments). This is, in effect, a1.3 times multiple, which is very high for any transaction, let alone an internalone. If interest is calculated on deferred payments, it is normally advisable to re-duce the multiple of revenues or compensation to take into account the full costof the buyout.

Retirement payments usually are deductible by the firm as compensation, andthey are taxed as ordinary income to the retiring partner. However, there is an in-creasing trend in the profession to treat at least a portion of buyout payments toretired partners as for the acquisition of goodwill or another asset amortizable fortax purposes under Sec. 197. This allows the retiring partner to treat the portionof the payment that is attributable to the goodwill buyout as capital gain, taxableat lower rates than ordinary income. But this treatment means that the firm can-not deduct that portion of the payments immediately; instead, it must be amor-tized over 15 years under Sec. 197. This increases the cost of the buyout to thefirm. For this reason, the most common approach remains treating internal buy-outs as retirement payments or, for firms that wish to find a more desirable taxtreatment for retired owners, stretching the payout period to 10 years or longer sothe payments can be treated in a manner that gives the retired owner capital gainstreatment without creating an unacceptable cost to the firm.

The Premise of Worth inan Accounting FirmGenerally, net assets in accountingfirms have two components: tangibleand intangible. Net tangible assetscomprise the assets less the liabilitieson an accrual-basis balance sheet.Those assets consist primarily ofcash and investments, billed and un-billed receivables, and fixed assets.There may be valuation allowancesthat warrant consideration, especial-ly for the receivables. However, itnormally is not difficult to arrive atnet tangible assets.

Issues usually arise with intangi-ble assets. Intangible assets com-prise what is often referred to as“blue sky,” which includes goodwill,workforce in place, and brandnames, as well as, potentially, otherintangible items. It is not unusualfor intangible assets to be two tofive times the value of tangible as-sets. Blue sky is based on the futureearnings capability of the business.In most accounting firms, thebiggest factor affecting future earn-ings is retention of clients and stafffollowing a change in control,whether that is due to an owner’sretirement or a sale.


are more likely to successfully manage afirm’s ownership transition if they:■ Promote an orderly transition of an

owner’s responsibilities to successorswithin the firm;

■ Motivate the successors within the firmto assume those responsibilities by cre-ating upside for those successors (see

sidebar, “Notice Required for Retire-ment”); and

■ Provide for and protect the firm’slong-term health and viability by al-lowing the firm to manage the buyoutobligations internally, using the fundsalready available through the firm’soperations. ❖

www.journalofaccountancy.com April 2012 Journal of Accountancy 33


AICPA RESOURCES

JofA articles■ “Traps for the Unwary in CPA Firm Mergers and Acquisitions,” Aug. 2011,page 36■ “Accounting Firm M&As: A Market Update,” Nov. 2010, page 30■ “Mergers & Acquisitions of CPA Firms,”March 2009, page 58, and “Keeping It Together,” April 2009, page 24 (two-partarticle)

Use journalofaccountancy.com to findpast articles. In the search box, click “OpenAdvanced Search” and then search by title.

Publications■ Management of an Accounting PracticeHandbook (#090407)■ Practice Continuation Agreements: APractice Survival Kit, Second Edition(#090211PDF, on-demand)■ Securing the Future: Building a Succes-sion Plan for Your Firm (#090486)

Conference■ Practitioners Symposium and TECH+Conference in partnership with the Associ-ation for Accounting Marketing Summit,June 11–13, Las Vegas

For more information or to make a purchase or register, go to cpa2biz.com orcall the Institute at 888-777-7077.

Website■ Private Companies Practice Section Succession Planning Resource Center,tinyurl.com/2vndhzw

Private Companies Practice Section The Private Companies Practice Section(PCPS) is a voluntary firm membershipsection for CPAs that provides memberfirms with targeted practice managementtools and resources, as well as a strong,collective voice within the CPA profession.Visit the PCPS Firm Practice Center ataicpa.org/PCPS.

Notice Required forRetirement Most agreements allow an owner toretire from the firm in a range ofages with full benefits or to leave atany time as long as adequate noticeis given. It is recommended thatpartner agreements require anowner to provide as much as twoyears’ notice of an intention to re-tire or otherwise leave to receivefull benefits. This usually leavesenough time to plan and executean orderly transition of duties andkey relationships.

In the event adequate notice isnot given, the preferable conse-quence is to subject the buyoutpayments to adjustment for thefirm’s loss of business during thetwo years following the owner’sexit under the premise such dimin-ishment of value was due to thelack of time to adequately transi-tion the retiring partner’s dutiesand relationships.

Example. A partner leaves thefirm without giving the notice thepartnership agreement requires.During the subsequent two years,the firm loses 10% of its business.The partnership agreement couldrequire a 10% reduction in thatpartner’s buyout payments. Theagreement could require measuringthe “lost business” on a firmwidebasis or restrict the measurement tothe portion of the business the de-parting partner was responsible formanaging.


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