8 Key Components of Accounting Firm Partnership Agreements – and Other Special Considerations
This article was originally published in 2019, and it continues to be among our most read articles. Much of the information shared in the article is applicable not only to accounting organizations, but to other professional services firms as well.
This article discusses accounting firm partnership agreements and addresses certain basic topics and other special areas for consideration.
Before we get started I want to clarify some terminology. First, “partnership agreement” includes and refers to shareholder agreements and LLC operating agreements in addition to traditional partnership agreements. Similarly, “partner” refers to a traditional partner as well as a shareholder of a corporation and a member of a limited liability company.
This article will cover the basic provisions in a partnership agreement including capital requirements, governance, restrictive covenants and retirement payments. It will also cover advanced topics such as transitioning from an equity based retirement model to a deferred compensation retirement model and claw-backs of retirement payments. My goal is for the reader to think about their own partnership agreement and provide tools and ideas to enhance their agreement.
By way of background, if a firm does not have a partnership agreement, the state law of the entity type governs. Therefore, whatever the Partnership Act of a particular state provides as its default provisions will govern. Those defaults may have little to do with what the partners had intended to govern their relationship. For example, there could be ambiguities around whether a partner would have the right to be bought out when the partner leaves and what the purchase price would be. If you don’t have one, you need one.
Governance
All partnership agreements have some basic form of governance. The basic premise is that absent an agreement to the contrary, the partners have all authority to act on behalf of partnership. However, in most partnership agreements, partners elect to cede certain of their powers to an executive committee and/or a managing partner. Even then, the partners usually retain certain prerogatives and rights. Those rights generally include election of the managing partner and the executive committee (and maybe other committees) and approval rights over major transactions and expenditures. These major transactions may include merging in of a smaller firm, new partner admissions, partner expulsions and significant financial matters (like borrowings in excess of a certain amount and/or capital expenditures over a certain amount). In most firms, the executive committee is the governing body with the authority to make or delegate all decisions (except the partner reserved decisions mentioned above) and the managing partner is responsible for day to day management. However, for firms that have a strong managing partner (this is often the case for founding partners), the partnership agreement will set forth certain things that the managing partner has the authority to do in his/her own right beyond the day to day business decisions. For example, the partnership agreement may provide that the managing partner has authority to bring in lateral partners or consummate small mergers.
As firms grow, governance tends to become more centralized. That is, there is less authority for the partners and more authority for the executive committee. This is a more efficient way to manage, but it means that partners lose autonomy. Also, as the firm grows, the election process itself becomes more complex. There may be a nominating committee for executive committee positions and the managing partner role. There may also be a run-off election process and there may be requirements for department representation. Recently we have seen requirements for gender diversity on executive committees. In a recent agreement, the firm allowed any partner to nominate himself/herself, but required prior approval by the executive committee. Terms, term limits and staggered terms are addressed in more complex agreements.
Finally, how partners vote must be addressed. The most common approach is voting by percentage ownership. Other voting mechanisms include per capita voting (one vote per partner), voting by capital account balances, and voting by last year’s compensation amounts. Firms decide which is right for them and in some cases, different voting methods are used depending on the decision. For example, some decisions are made by majority (approval of a major expenditure), but others are made by a supermajority of 75% (removal of a partner).
Capital
All firms need capital for both working capital purposes and for investment purposes. Typically, a firm admitting a new partner will require a capital contribution from that partner. That capital contribution may be a fixed amount (for example, $150,000) or some percentage of compensation. Some firms have an equity model where a partnership interest is acquired at the firm’s valuation either from the firm itself or from other partners.
In most instances, upon the admission of a new partner, the contribution of capital is made over a period of time so as not to reduce the new partner’s take home pay when he or she first becomes a partner. However, several firms require an upfront payment and have an arrangement with a bank for partners to get capital loans. In a merger, the merging-in partners will generally be required to put in their capital that is available from their existing firm and fund any deficiency in a relatively short period of time. The partnership agreement should also provide for a mechanism to call capital or retain capital in proportion to either partner compensation or percentage interest in the firm. In concept, firms with consulting or other practices can raise outside capital for those businesses, but this is rarely done in practice. There is typically interest paid on capital at the prime rate plus a percentage that can be adjusted by the executive committee.
Once a partner leaves, that partner’s capital is returned. It is usually returned in a one to three year payout period with two years being the most common. Capital is subject to set-off for any amount that the partner owes to the firm. Additionally, consider whether your partnership agreement should have a provision that says that the retired partner’s capital account will be charged for its proportionate share of any contingent claims.
Retirement
The vast majority of firms provide for mandatory retirement. The larger the firm the younger the age seems to be. The retirement age is generally somewhere in the 62 to 70 range. There used to be a trend toward younger mandatory retirement ages, but in the last few years I see the age trending up, probably more to a 67 midpoint (but 65 is still very common). Most partnership agreements will allow for early retirement starting at age 55 to 60, provided that the partner has a specified number of years of service as a partner (e.g., 15 years). My own experience is that early retirement is often talked about but rarely used. Partners are generally not in a position to retire at 55 or 60. Additionally, many partners don’t want to retire as they find this to be the area in life where they are most effective. The notice period for early retirement should be long, probably two years, in order to allow for the proper transition of clients.
The partnership agreement should require all retirees to have a transition plan. The transition plan is critical in order to make sure that the firm retains the clients and other skills and abilities of the retiring partner. It is now quite common to have penalties for failure to give the requisite notice or failure to prepare and adhere to a transition plan. I like to give the executive committee latitude (within a range) to reduce retirement payments in the event of such a failure. The transition plan itself is something that will be developed by the retiring partner in consultation with and ultimate approval of the managing partner or the managing partner’s designee. As an example, I recently drafted a partnership agreement allowing the executive committee to reduce a retiree partner’s payments by up to 50% for failure to give the requisite notice or failure to adhere to the transition plan.
Retirement benefits typically have a vesting period. It is not uncommon for the vesting to be over a 20-year period. Some firms give partial or full credit for years as an income partner. Of course, merged-in partners will be given credit for the period of time they were a partner at their old firm. Death and disability usually should not accelerate vesting, although in some firms they do.
The retirement payment payout period is typically 10 years. Additionally, the total aggregate amount payable to retired partners each year is capped at some portion of the annual revenue or net income of the firm (for example, 4% of the revenue of the firm). This is to ensure that the firm continues as a financially healthy organization while it is paying out the retired partners. Sometimes, founding partners have better terms on their buy-outs. Retirement payouts typically do not accrue interest, although this is not universal.
Many firms obtain life insurance on their partners in order to fund some or all of the buy-out payments. I think there is logic here in that on a death, there is less time to transition the business. There is usually a discussion around whether the partner has the right to take their insurance after retirement. Most firms do not allow for this.
Finally, many partners want to work after they “retire.” In essence, they give up their equity and become employees. Our recommendation is to have year-to-year contracts in these situations to manage expectations. Typically, retired equity partners are paid on their personal productivity and for new clients. There are also self-employment tax issues that need to be considered on the retirement payments if the firm also continues to compensate the partner for services rendered after retirement.
Restrictive Covenants
Restrictive Covenants (non-competes and non-solicits) are what create a significant part of the goodwill of an accounting firm. Contrast this with law firms that are not allowed to have restrictive covenants. Few law firms have retirement payments because they cannot enforce restrictive covenants. Client relationship are also longer lasting and more deeply embedded with accountants than with lawyers, which provides another reason why accounting firms can support a retirement payment and law firms generally cannot.
In addition to a restriction on client solicitation, I like to add a restriction on solicitation of referral sources. For many accountants, referral sources are as important as the clients themselves. This is particularly true in certain practice areas, like litigation support. Referral source non-solicits may be harder to enforce, but in most cases are worthwhile. We usually counsel against pure non-compete agreements. They are hard to enforce as courts often view them as not being needed to protect the business interests of the firm and it is easier for a court to enforce something that the judge thinks is reasonable, and true non-competes are sometimes viewed as being unreasonable. There are exceptions to this. In one case we prepared a non-compete in a designated geographical area and for a certain industry for which the firm had developed proprietary tools and a large market share of clients in that industry. Restrictive covenants last anywhere from two to five years depending on the state. Some states will allow them to last for the duration of the buy-out period. Another technique is to provide that all future retirement payments are forfeited if the former partner solicits clients, even after the restriction period.
Most firms have a liquidated damages provision for restrictive covenant breaches. In other words, the partnership agreement describes how damages will be determined if a partner leaves and takes clients or employees. This makes sense because in most cases if a client wants to follow a partner, the old firm will not retain that client anyway. Typically, we recommend liquidated damages in the range of 125-150% of the client’s billings over a period of time. If the percentage is much higher, we are concerned that the judge will disregard the amount. Additionally, the partnership agreement should make the former partner responsible for the unpaid receivables of any client he or she takes. Similarly, with respect to poached employees, liquidated damages are usually in the range of 50-75% of annual compensation.
Amendments
Amendments typically require a super majority vote of the partners, regardless of whether voting is per capita or based upon a percentage interests (two-thirds seems to be the right percentage in most cases). Additionally, there may be restrictions on amendments to reduce retirement benefits to partners who are near the mandatory retirement age, unless a majority of those more senior partners agree to the reduction.
Arbitration vs. Court. We generally recommend arbitration in order to keep disputes out of the public domain. Large firms will sometimes have an internal body of neutral partners decide certain disputes, for example, how a retirement payment provision is interpreted.
Indemnification
Typically, a partnership agreement will provide that a partner is liable to the firm for acts of gross negligence or willful misconduct to the extent the actions are not covered by insurance. In all other instances, the firm will indemnify a partner in connection with the partner’s work at the firm.
Compensation
Compensation is not something we think should be addressed in the partnership agreement. In some firms it is indirectly addressed because compensation follows equity ownership. We typically do not agree with this approach and believe that compensation should be tied to performance rather to percentage ownership. In those equity based models where compensation, partially or wholly, follows percentage ownership rather than the performance, we see problems being able to give compensation incentives to younger partners.
Dissolution
While rarely used, all partnership agreements should have a dissolution section addressing what will happen if the firm dissolves. After dissolution, the firm may no longer have the right to enforce restrictive covenants because it no longer has a protectible interest in its business. Therefore, without something in the agreement, any partner can take clients without payment and there would be no way to fund retirement payments owed to previously retired partners or those nearing retirement at the time of dissolution. Therefore, it is important to require partners to pay for the clients that they take after the firm dissolves. If the firm is sold or merged, rather than dissolved, the dissolution provision will often have to be overridden by agreement of the partners because the merger consideration will likely be distributed in a different fashion than is specified in the partnership agreement.
Following are some special topics.
Transitioning Between Retirement Systems
In the course of the evolution of a firm, it often becomes appropriate to transition between retirement systems. For example, a firm might begin life using a “book of business” approach, that is, the partnership will pay for someone’s book of business when they retire. As the partnership matures, the firm might find that a book of business approach results in partners behaving in a manner that may not be in the best interests of the firm, and the firm may move to a deferred compensation or equity based model to pay partners on retirement. Similarly, a firm with an equity based model may change to a deferred compensation model. This type of change is often intended to prevent founding partners from getting too much on retirement based on their founding equity percentage. However, firms with an equity based model have ways to address this besides converting to a deferred compensation model. For example, they may require purchases and sales between partners in order to ameliorate the effects of historical highly disproportionate equity allocations. When moving from one system to another, care needs to be taken to avoid disadvantaging those who grew up in the firm and are at or near retirement under the old system. For example, we may use floor amounts for partners over a certain age. Another option is to maintain two separate systems and give the legacy partners the ability to get the higher of the two systems.
Classes of Partners
Many firms have multiple classes of partners. Income partnership is the most common distinction from equity partnership. Income partners typically do not make a capital contribution and do not have voting rights. Some firms (but not most) will pay some sort of deferred compensation to income partners when they retire (for example, one times earnings). Note that a mandatory retirement age typically would not be appropriate for income partners because in all likelihood they will be considered employees under federal law, regardless of whether they get a K-1 or W-2, and as such are protected against age discrimination arising from a mandatory requirement that their employment terminate at a certain age.
Contrast this with a growing number of firms that are implementing two-tier equity partner structures. Firms often take the position that both tiers are owners and that mandatory retirement can apply to both. There is meaningful risk on this issue as the lower tier may not be viewed as owners in the eyes of the law. This is a fact and circumstances test as to the indicia of ownership that is beyond the scope of this article. Suffice it to say that things like requirements to put capital at risk, sharing of profits and losses, and voting and control rights go into the analysis. Typically, the lower tier of equity partners will get some payment on retirement.
A couple of other things to note. Restrictive covenants (like client non-solicits) are generally more enforceable and for longer periods on the sale of a partnership interest itself. Therefore, in some states, covenants for equity partners are analyzed under difference standards than for income partners. I typically recommend that income partners sign a separate agreement and not the partnership agreement. This leads to a cleaner delineation of the positions. One note of caution: be careful with introducing a second class of equity partners into an S-Corporation.
Claw-backs
I’ve been seeing a comeback in retirement “claw-back” provisions. These essentially operate to reduce otherwise expected retirement payments if the retired partner’s book of business does not stay after the partner’s retirement. Several years ago firms were moving away from claw-back, but now, at least anecdotally, I see firms using them again, at least in a limited manner. So, for example, you might see an approach where if the partner’s historical book falls by 20% or more in the 24 month period after retirement, then the retirement payments will be reduced on a pro-rata basis up to an aggregate, for example, of 15% of the retirement payments. As this example illustrates, there is usually a buffer zone and there is usually a maximum on the retirement benefit amount that could be clawed-back.
Retirement Payment Protections
Retirement payment protections are things you might see in firms that still have their founders. These protections may include personal guarantees of retirement payments by the remaining partners, the right to vote on certain matters (like a merger) and a security interest in the assets of the firm. You typically do not see these things in more mature firms and they can often hinder the ability of the firm to grow and combine with other firms.
Fiduciary Fees
Finally, I want to touch on fiduciary fees. Fiduciary fees can include executor fees, trustee fees, guardianship fees and director fees. The fees collected by a partner for those services should be paid to the partnership while the partner remains at the firm (I’ve seen exceptions for very large trusts). However, after retirement and while receiving retirement payments, it is common to split these fees in some fashion. Because the partner’s retirement payment generally relates to his or her historical compensation, it is appropriate for the retired partner to share these fees with the firm. A 50-50 split is not uncommon.