8 Factors that Determine a Retired Partner’s Deferred Compensation

When partners retire, it goes without saying that they want to cash in their share of the firm’s value. But they want to do this in a way that enables the firm to continue as a successful, viable entity.   This is accomplished by creating a partner retirement/buyout plan.

How deferred compensation will be treated is a topic every well-crafted plan must address, with due consideration given to the issues below:

1. Overall goodwill valuation.  The starting point for creating a CPA firm partner retirement/buyout plan is selecting the overall valuation percentage for the firm’s total deferred compensation (we refer to this as goodwill throughout this blog).   Decades ago, it was a foregone conclusion that the valuation would be one times fees.  But for 10-20 years, the average goodwill valuation in the CPA firm industry has settled at roughly 80% of fees.  Many firms are still at 100%, but many are below 80%.  There are several reasons for the reduced valuation.  One has been a deliberate effort by firms to be more conservative, thus making the plan appear more affordable to new partners.
2. Computing the amount of an individual partner’s interest in the goodwill.  The Multiple of Compensation method is by far the most popular system.  Common example:  The plan provides for goodwill benefits of 3 times compensation.  If the compensation of a retiring partner averages $300,000 towards the end of his tenure as an owner, he is paid $900,000 over a period of years.  The multiple is often selected to net an overall goodwill valuation that the firm desires.  Other commons systems are: (a) AAV system, which provides for partners to share in the goodwill value of the firm’s as its revenues increase, and (b) Book of business system, which provides for goodwill benefits to be linked directly to the size of one’s client base.  Larger and/or more sophisticated firms shy away from the book of business method because it is inconsistent with the “one-firm” concept.
3. Reductions that factor in non-traditional services that will leave when the partner retires (examples include business valuations and litigation support).
4. Reductions that are essentially penalties for failing to provide the proper notice of intent to retire (most firms require one to two year’s notice) and/or failure to proactively transition clients to other firm members.
5. Vesting.  Almost all firms provide for vesting of goodwill benefits.  Two types of vesting are quite common: Years-as-a-partner based, usually 10-20 years, and age-based, which requires a partner to reach a certain age, usually at least 60, before benefits are fully vested.  Most firms provide for both types of vesting simultaneously.  Firms don’t want to allow for a situation in which a partner can become fully vested at a relatively young age, say 55 or earlier.  Firms like to structure the vesting schedule to encourage partners to stay around for the long haul.
6. Payout term.  The vast majority of firms pay out goodwill over 10 years.  A more rapid payout can result in an onerous cash flow strain on the firm.
7. Tax treatment of the payments.  Virtually all firms provide for goodwill payments to be taxed as ordinary income to the recipient.
8. The math must work.  The acid-test of the viability of a firm’s partner buyout plan is this:  When a partner retires, the remaining partners should ideally earn more money or at the least, earn the same amount of money as before the person retired.  Here’s the way this should work:  The savings to the firm by no longer compensating the retiree should exceed her retirement payments and the compensation paid for any new staff that is hired.  If the test is failed, it is unlikely that the partners will tolerate this, and they will want to make the retirement benefits less lucrative to make the math work.