Who Is Reviewing Your Firm's Partnership Agreements?

We often find that many of our clients, including law firms, do not involve their accountants in the development or review of their shareholder/partnership operating agreements. These are complex agreements that involve legal, financial and tax considerations. They require the expertise of an experienced attorney who specializes in these matters. They also require the assistance of the client's CPA firm and possibly their insurance advisers. Involving all of the right parties from the start will help you avoid pitfalls and craft an effective agreement that can weather the test of time.

There are many factors that need to be addressed when developing these complex legal documents. Some significant factors that should be considered are as follows:

• Type of legal entity (C corporation, S corporation, General Partnerships (“GP”), Limited Liability Partnerships (“LLP”) or Limited Liability Company (“LLC”));
• The laws of the state(s) in which the firm is organized, domiciled and conducts business activities;
• Consistency between the partnership agreement and the partner's employment agreement;
• Number of partners;
• Disparity/concentration in the ages of the partners (Consider questions such as: Are several partners expected to retire around the same time?);
• Importance of significant rainmakers (originators) and the impact of their departure from the firm;
• Valuation issues related to allocations between the redemption price for ownership interests and deferred compensation;
• Types of benefits to be provided to departing owners and the funding of these benefits;
• Single or multiple levels of ownership/income allocation arrangements;
• Existence of multiple practice areas or reliance on one practice area;
• Governance issues related to the admission of new partners and related capital contribution requirements;
• Governance issues related to the determination of owner compensation;
• Financial position of the firm and its ability to pay the benefits outlined in the agreement;
• Capital structure and anticipated capital requirements of the firm;
• Method(s) of accounting used for income tax and financial reporting purposes; and
• Existence of life and disability insurance coverage on the owners and the structure of these policies.

While all the issues above must be addressed when developing an agreement, this article will focus on the specific areas where the accountant should be involved in this process and the specific areas of the agreement that require an accountant's expertise.

Role of the CPA

The role of the CPA is very important because many agreements specify that the accountant will be responsible for performing certain computations. These computations relate to various events that may occur during the life cycle of the firm.

If your CPA is involved during the planning and drafting stages, he or she should gain an understanding of the financial terms of the agreement and how the law firm expects to fulfill these terms. Your accountant should meet with the attorney drafting the document and key members of your law firm. Proper planning requires an assessment of the firm's ability to meet the obligations set forth in the agreement. Your CPA can help with this assessment by modeling the payment of expected obligations under various scenarios.

Once the document is drafted, the terms of the agreement need to be communicated to the owners. Your CPA and the drafting attorney should meet with the owners to explain the most significant terms.

Terminology and Definitions

It is imperative that the terminology in the agreement is appropriate and the terms are properly defined. Many poorly drafted agreements refer to unclear technical or measurement terms. All technical terms should be listed in a definition section that is understandable to those who will implement the terms of the agreement. The CPA charged with the ultimate responsibility of performing computations should review the agreement to make sure the language surrounding the financial and tax aspects of the agreement is not subject to misinterpretation.

Accounting Issues

It is important for your CPA to understand the accounting method(s) and principles that the law firm uses for financial statement and income tax reporting. Many law firms maintain their books on the income tax basis of accounting, also known as the cash basis of accounting, modified for amortization and depreciation, and they adopt this method for income tax reporting purposes. Some law firms also generate accrual basis financial information to make informed management decisions. This accrual basis information may or may not be in accordance with Generally Accepted Accounting Principles (“GAAP”).

Your CPA must first determine if the terms in the agreement refer to a method of accounting that the firm uses. For example, does the agreement refer to accrual basis or GAAP financial data (i.e., book value, income before income taxes or net income) while the firm only maintains its books on the cash basis method (modified for amortization and depreciation)? Your CPA must ascertain if it is management's intention to create accrual basis or GAAP financial statements strictly for purposes of applying the terms of this agreement.

Your CPA must consult with firm management to ensure that they understand how the firm's historical financial data will be used in the application of various provisions within the agreement. For example, the agreement may specify GAAP reporting. This would require the firm to include work-in-process, accounts receivable, accounts payable and other accrued expenses in certain computations. It may also require the adjustment of amortization and depreciation to comply with lives and methods acceptable under GAAP. The reference to this method may have unintended consequences.

To illustrate an unintended consequence of selecting GAAP reporting, adequate allowances for unbillable and uncollectible amounts must be applied. How will these allowances be determined? Is there precedent for the approach for determining these allowances? These allowances may have significant implications in applying the provisions of the agreement using GAAP. A CPA is uniquely qualified to advise the firm in matters related to the choice and application of accounting methods and issues.

Valuation and Allocation Issues

Your CPA should review the agreement to determine if it requires a valuation of the law firm or of specific ownership interests. If so, does the agreement address the standard of value to be used? Is there a specific formula outlined in the agreement? Does the agreement address the inclusion or exclusion of discounts for lack of marketability or control? If so, your CPA should advise you regarding the possible implications of these requirements.

Valuation issues to be considered include:

• Is the valuation to be prepared on an annual basis?
• Is the valuation date clearly spelled out if the valuation is being prepared in connection with a triggering event (death, disability, voluntary or involuntary termination)?
• Is it clear who will prepare the valuation?
• Is it binding on all parties?

Your CPA will also provide valuable insight related to valuation issues and the distinctions between the amounts to be paid for ownership interests and deferred compensation. This is an important distinction because the amounts allocated for the purchase of ownership interests and deferred compensation are treated differently for income tax purposes, and there are advantages and disadvantages to the firm and the departing partner based on the ultimate allocation.

Ability of the Entity to Meet the Obligations of the Agreement

One of the primary concerns that firm management must address in the agreement planning stage is their ability to pay the obligations spelled out in the agreement and maintain an acceptable level of profitability for the remaining partners.

Therefore, the amounts to be paid to the departing partner on an annual basis must be low enough to account for the cost of replacement personnel and allow for the potential loss of business originations normally generated by the departing partner. This is especially important if the departing person is a rainmaker who originates a significant portion of the firm's new business or is critical to maintaining existing business relationships. By curtailing annual payments to the departing partner, the remaining partners should be able to maintain their earnings levels, assuming all other things are equal.

During the planning stage, your CPA can help analyze and determine the total amount expected to be paid out to a departing partner for his or her ownership interest (stock or capital account) and deferred compensation. Once the total amount to be paid is calculated, a pay-out period should be chosen that allows the firm to maintain its profitability levels and cash flow requirements.

What if the firm has simultaneous obligations to more than one departing partner? Certain restrictions should be built into the agreement to limit the total annual commitment for payments to departed partners. The limitations on amounts to be paid may be stated as a dollar amount or as a percentage (e.g., of the law firm's gross receipts or net income). This need for limitations is especially relevant when more than one key person is expected to leave within a short period of time. One of the goals of the agreement is to protect the firm from excessive pay-outs that jeopardize its future.

Measurement Dates

Your CPA needs to understand the measurement dates in the shareholder/partnership and employment agreements to be able to accurately calculate the firm's financial obligations; therefore, it's imperative that these dates are very specific.

For example, let's assume that a law firm had a calendar year-end, and partner compensation was determined at the end of the fiscal year (Dec. 31). Also assume that a partner died on July 18. Does the agreement clearly state the measurement dates to be used to compute amounts to be paid to the departing partner for his or her ownership interest and deferred compensation? Does it indicate the date of departure, the last day of the previous month or the last day of the previous fiscal year?

Using different dates can produce significantly different results. To illustrate, many firms make income allocation decisions related to the partner group at year-end. As a result, the equity of the firm is typically at its lowest point at year-end. As the year progresses, profits are accumulated and the equity grows. Therefore, computations based on the equity of the firm (cash or accrual basis) are affected by the measurement date.

Another issue that the firm may want to address is how a departing partner will be compensated if he or she departs before the end of a fiscal year as a result of death or disability. Should the agreement be silent, or should it include language to cover this situation?

Use of Examples

Does the document contain examples to clarify financial computations? These examples may assist with the interpretation of financial computations described within the agreement. Your CPA should review these examples to assure that they reconcile with the wording in the agreement and that they reflect his understanding of management's intentions.

In conclusion, giving your CPA a seat at the table with the drafting attorney during the development and review of shareholder/partnership agreements will help ensure that all legal, financial and tax implications are accounted for with your law firm's best interests in mind.

Steven A. Davis, CPA, leads the Accounting Services practice at Kaufman, Rossin & Co. He provides internal control and sophisticated consulting engagements to law firms. He can be reached at [email protected]. Louis Balbirer, CPA, MST, is a director of tax services with Kaufman, Rossin & Co. He has 20 years of experience providing tax and accounting services to clients and can be reached at [email protected].

We often find that many of our clients, including law firms, do not involve their accountants in the development or review of their shareholder/partnership operating agreements. These are complex agreements that involve legal, financial and tax considerations. They require the expertise of an experienced attorney who specializes in these matters. They also require the assistance of the client's CPA firm and possibly their insurance advisers. Involving all of the right parties from the start will help you avoid pitfalls and craft an effective agreement that can weather the test of time.

There are many factors that need to be addressed when developing these complex legal documents. Some significant factors that should be considered are as follows:

• Type of legal entity (C corporation, S corporation, General Partnerships (“GP”), Limited Liability Partnerships (“LLP”) or Limited Liability Company (“LLC”));
• The laws of the state(s) in which the firm is organized, domiciled and conducts business activities;
• Consistency between the partnership agreement and the partner's employment agreement;
• Number of partners;
• Disparity/concentration in the ages of the partners (Consider questions such as: Are several partners expected to retire around the same time?);
• Importance of significant rainmakers (originators) and the impact of their departure from the firm;
• Valuation issues related to allocations between the redemption price for ownership interests and deferred compensation;
• Types of benefits to be provided to departing owners and the funding of these benefits;
• Single or multiple levels of ownership/income allocation arrangements;
• Existence of multiple practice areas or reliance on one practice area;
• Governance issues related to the admission of new partners and related capital contribution requirements;
• Governance issues related to the determination of owner compensation;
• Financial position of the firm and its ability to pay the benefits outlined in the agreement;
• Capital structure and anticipated capital requirements of the firm;
• Method(s) of accounting used for income tax and financial reporting purposes; and
• Existence of life and disability insurance coverage on the owners and the structure of these policies.

While all the issues above must be addressed when developing an agreement, this article will focus on the specific areas where the accountant should be involved in this process and the specific areas of the agreement that require an accountant's expertise.

Role of the CPA

The role of the CPA is very important because many agreements specify that the accountant will be responsible for performing certain computations. These computations relate to various events that may occur during the life cycle of the firm.

If your CPA is involved during the planning and drafting stages, he or she should gain an understanding of the financial terms of the agreement and how the law firm expects to fulfill these terms. Your accountant should meet with the attorney drafting the document and key members of your law firm. Proper planning requires an assessment of the firm's ability to meet the obligations set forth in the agreement. Your CPA can help with this assessment by modeling the payment of expected obligations under various scenarios.

Once the document is drafted, the terms of the agreement need to be communicated to the owners. Your CPA and the drafting attorney should meet with the owners to explain the most significant terms.

Terminology and Definitions

It is imperative that the terminology in the agreement is appropriate and the terms are properly defined. Many poorly drafted agreements refer to unclear technical or measurement terms. All technical terms should be listed in a definition section that is understandable to those who will implement the terms of the agreement. The CPA charged with the ultimate responsibility of performing computations should review the agreement to make sure the language surrounding the financial and tax aspects of the agreement is not subject to misinterpretation.

Accounting Issues

It is important for your CPA to understand the accounting method(s) and principles that the law firm uses for financial statement and income tax reporting. Many law firms maintain their books on the income tax basis of accounting, also known as the cash basis of accounting, modified for amortization and depreciation, and they adopt this method for income tax reporting purposes. Some law firms also generate accrual basis financial information to make informed management decisions. This accrual basis information may or may not be in accordance with Generally Accepted Accounting Principles (“GAAP”).

Your CPA must first determine if the terms in the agreement refer to a method of accounting that the firm uses. For example, does the agreement refer to accrual basis or GAAP financial data (i.e., book value, income before income taxes or net income) while the firm only maintains its books on the cash basis method (modified for amortization and depreciation)? Your CPA must ascertain if it is management's intention to create accrual basis or GAAP financial statements strictly for purposes of applying the terms of this agreement.

Your CPA must consult with firm management to ensure that they understand how the firm's historical financial data will be used in the application of various provisions within the agreement. For example, the agreement may specify GAAP reporting. This would require the firm to include work-in-process, accounts receivable, accounts payable and other accrued expenses in certain computations. It may also require the adjustment of amortization and depreciation to comply with lives and methods acceptable under GAAP. The reference to this method may have unintended consequences.

To illustrate an unintended consequence of selecting GAAP reporting, adequate allowances for unbillable and uncollectible amounts must be applied. How will these allowances be determined? Is there precedent for the approach for determining these allowances? These allowances may have significant implications in applying the provisions of the agreement using GAAP. A CPA is uniquely qualified to advise the firm in matters related to the choice and application of accounting methods and issues.

Valuation and Allocation Issues

Your CPA should review the agreement to determine if it requires a valuation of the law firm or of specific ownership interests. If so, does the agreement address the standard of value to be used? Is there a specific formula outlined in the agreement? Does the agreement address the inclusion or exclusion of discounts for lack of marketability or control? If so, your CPA should advise you regarding the possible implications of these requirements.

Valuation issues to be considered include:

• Is the valuation to be prepared on an annual basis?
• Is the valuation date clearly spelled out if the valuation is being prepared in connection with a triggering event (death, disability, voluntary or involuntary termination)?
• Is it clear who will prepare the valuation?
• Is it binding on all parties?

Your CPA will also provide valuable insight related to valuation issues and the distinctions between the amounts to be paid for ownership interests and deferred compensation. This is an important distinction because the amounts allocated for the purchase of ownership interests and deferred compensation are treated differently for income tax purposes, and there are advantages and disadvantages to the firm and the departing partner based on the ultimate allocation.

Ability of the Entity to Meet the Obligations of the Agreement

One of the primary concerns that firm management must address in the agreement planning stage is their ability to pay the obligations spelled out in the agreement and maintain an acceptable level of profitability for the remaining partners.

Therefore, the amounts to be paid to the departing partner on an annual basis must be low enough to account for the cost of replacement personnel and allow for the potential loss of business originations normally generated by the departing partner. This is especially important if the departing person is a rainmaker who originates a significant portion of the firm's new business or is critical to maintaining existing business relationships. By curtailing annual payments to the departing partner, the remaining partners should be able to maintain their earnings levels, assuming all other things are equal.

During the planning stage, your CPA can help analyze and determine the total amount expected to be paid out to a departing partner for his or her ownership interest (stock or capital account) and deferred compensation. Once the total amount to be paid is calculated, a pay-out period should be chosen that allows the firm to maintain its profitability levels and cash flow requirements.

What if the firm has simultaneous obligations to more than one departing partner? Certain restrictions should be built into the agreement to limit the total annual commitment for payments to departed partners. The limitations on amounts to be paid may be stated as a dollar amount or as a percentage (e.g., of the law firm's gross receipts or net income). This need for limitations is especially relevant when more than one key person is expected to leave within a short period of time. One of the goals of the agreement is to protect the firm from excessive pay-outs that jeopardize its future.

Measurement Dates

Your CPA needs to understand the measurement dates in the shareholder/partnership and employment agreements to be able to accurately calculate the firm's financial obligations; therefore, it's imperative that these dates are very specific.

For example, let's assume that a law firm had a calendar year-end, and partner compensation was determined at the end of the fiscal year (Dec. 31). Also assume that a partner died on July 18. Does the agreement clearly state the measurement dates to be used to compute amounts to be paid to the departing partner for his or her ownership interest and deferred compensation? Does it indicate the date of departure, the last day of the previous month or the last day of the previous fiscal year?

Using different dates can produce significantly different results. To illustrate, many firms make income allocation decisions related to the partner group at year-end. As a result, the equity of the firm is typically at its lowest point at year-end. As the year progresses, profits are accumulated and the equity grows. Therefore, computations based on the equity of the firm (cash or accrual basis) are affected by the measurement date.

Another issue that the firm may want to address is how a departing partner will be compensated if he or she departs before the end of a fiscal year as a result of death or disability. Should the agreement be silent, or should it include language to cover this situation?

Use of Examples

Does the document contain examples to clarify financial computations? These examples may assist with the interpretation of financial computations described within the agreement. Your CPA should review these examples to assure that they reconcile with the wording in the agreement and that they reflect his understanding of management's intentions.

In conclusion, giving your CPA a seat at the table with the drafting attorney during the development and review of shareholder/partnership agreements will help ensure that all legal, financial and tax implications are accounted for with your law firm's best interests in mind.

Steven A. Davis, CPA, leads the Accounting Services practice at Kaufman, Rossin & Co. He provides internal control and sophisticated consulting engagements to law firms. He can be reached at [email protected]. Louis Balbirer, CPA, MST, is a director of tax services with Kaufman, Rossin & Co. He has 20 years of experience providing tax and accounting services to clients and can be reached at [email protected].