A Solution To Firm Retirement Problems

How to ease the cash flow impact of funding partner benefits.

  • MOST CPA FIRMS FACE A HUGE FINANCIAL liability to their retired and soon-to-retire partners. Few firms have developed a satisfactory solution to this problem. In most instances, the typical firm does not prefund its retirement plan because there is no current income tax deduction for doing so.

  • THE RESULT IS THAT MOST FIRMS DEAL WITH retirement obligations on a pay-as-you-go basis, which reduces the firm's distributable income available to current partners. This arrangement stays in effect by default because partners are reluctant to devote firm resources to prefunding the retirement benefits.

  • A GROWING RETIREMENT OBLIGATION CAN THREATEN a firm's stability, make it difficult to recruit new employees and cast doubt on the firm's ability to pay anyone—current retirees, soon-to-retire partners and younger partners when their time comes.

  • CPA FIRMS CAN ADOPT A PLAN THAT USES variable life insurance policies on partners' lives and bank loans to cut the cost of partner retirement benefits. Policy loans, withdrawals and death benefits-all tax-free-fund 100% of required retirement payments. Insurance funding comes from the firm's fixed commitment to pay premiums to the trust and from a bank loan to help meet firm operating costs.

  • THE RESULT IS A DRAMATIC CUT IN A FIRM'S aftertax retirement costs. Cash flow is more predictable because the funding obligation is preset, partners close to retirement know their benefits will be paid and younger partners are relieved of the burden of paying off a growing pool of retiring partners.
Irving L. Blackman , CPA, JD, is a founding partner of Blackman Kallick Bartelstein, LLP in Chicago. He can be reached by e-mail at IBlackman@bkbcpa.com .

Bringing in new business, hiring good staff and avoiding malpractice liability are ongoing problems for almost every CPA firm. Each firm must successfully deal with these issues if it is to grow and prosper. But an even bigger problem for most firms is the financial liability to retired and soon-to-retire partners. Those obligations usually include an income stream to the retiring partner for a fixed period, a capital buyout and health care benefits.

Until the concepts explained in this article were developed, I had never found a firm—including our own—that had developed a satisfactory solution to the financial aspects of the partner retirement problem. Although the concepts discussed here in no way solve—or attempt to solve—the cash flow problems of compensating already-retired partners, they will help CPA firms provide retirement payments to partners who are not yet entitled to receive them.

Typically, a CPA firm's retirement plan is not funded—the firm has made no attempt to set aside in advance the funds needed to pay future retirement obligations. The lack of a current income tax deduction for funding the plan makes prefunding economically unrealistic for most firms. The pressure on a growing firm to finance work-in-process and accounts receivable creates cash flow problems of its own. Who would even dream of letting up on the new—business quest for the sake of improved cash flow? The suggestion of cutting off even a small portion of cash flow to partially fund a future retirement obligation gets the "it-can-wait" answer at most firms.

The result is a pay-as-you-go plan that forces the firm to pay benefits out of current cash flow. This represents a direct hit on the firm's distributable income. Because every partner reaches retirement age sooner or later, the pay-as-you-go plan is no longer tomorrow's problem.

Cash payments begin now. This typically places the burden on active partners. Prefunding for additional retirees would burden the same partners even more. This double hit—paying cash to retired partners (deductible) and prefunding for future benefits (not deductible)—is not economically feasible for a growing firm. As a result, the pay-as-you-go retirement plan stays in place by default. As the retirement liability grows, the current or potential cash flow shortage also increases, becoming a circular, ever-growing problem.

In most CPA firms, three major groups evolve:

  • Retired partners . This group is concerned about the firm's ability to continue paying the agreed-upon benefits. These elders started the firm and built the practice, struggling with sparse distributions to help fund initial growth. For their sacrifices, they feel entitled to every penny the firm owes them.
  • Soon-to-retire partners . This group is concerned about the firm's ability to meet a growing obligation and wonders if the money will be there when it's their turn to retire. Attitudes differ depending on a particular partner's years to retirement and how likely it is the firm's ability to pay will change. Noncompete agreements usually make it economically impossible for this group to leave the firm before retirement—either alone or in a group. While these partners are likely to join the retired partners in advocating firm continuity, merger beckons as one way to make sure they get their share when the time comes.
  • Young partners . This group is driven by concern about having to bear the current cost of future retirement liabilities for those who have already retired and those who will retire soon. They view these obligations as a nonrefundable tax on current distributable income rather than as an investment in their future. It's difficult to explain to young accountants that the firm's prosperity required sacrifice by others that began even before they were born. Because they see themselves as the firm's future, these partners feel they are entitled to be paid for their work—in cash—at a market rate or better. Otherwise, they will weigh their options to go elsewhere. They are young enough to weather the typical one- to three-year covenant period of a noncompete agreement.

To compound the problem, the exact amount of a firm's retirement liability is a moving target. The firm adds new partners of varying ages (to fill gaps in the firm's technical needs, to add new services or to increase traditional ones) and old partners sometimes leave (for reasons other than death, disability or retirement). As a result of firm growth and inflation, almost all current partners will earn more (on the accrual basis) over time than their predecessors. Unfortunately, this amount is not necessarily available for cash distributions. All of these factors affect the firm's retirement liability. As time passes, the pay-as-you-go option becomes increasingly untenable and can threaten the firm's continuity.

Once a firm's retirement obligation begins to threaten its stability, three related issues can compound the problem.

  1. The larger the firm's retirement liability, the tougher it is to recruit new employees. A firm might as well admit to the problem up front—such secrets cannot be kept very long. When new employees find out the extent of the problem, frequently they are out the door.
  2. If a large cluster of partners is at or near the same retirement age, the problem is potentially even more serious.
  3. Even a small exodus of partners from the firm puts a disproportionate financial burden on remaining partners. If enough partners leave, a firm's ability to stay in existence, let alone pay retirement benefits, diminishes greatly. Retired or about-to-retire partners may be left holding a bag of empty promises.

Can a firm survive without solving the problem? Perhaps not. I predict those CPA firms that solve their retirement liability problem will have a huge competitive advantage in the future.

Here are some common solutions accounting firms have available to them to solve retirement problems.

  1. Establish qualified plan(s) to the extent allowed by law.
  2. Create and fund a nonqualified plan to make up any shortfall. However, even if the funds are placed in a Rabbi trust, a partner is not protected if the firm goes broke.
  3. Increase the firm's retirement age.
  4. Cap the percentage of partnership income (gross or net) per year that is payable to retired partners (sometimes with a carryover of unpaid amounts).
  5. Reduce payments to already retired partners and those about to retire.
  6. Fund preretirement death benefits with life insurance. In a successful firm with high-earning partners (those who earn substantially in excess of qualified plan contribution and benefit limits), you can accurately predict which of these solutions might be embraced or rejected by each of the three partner groups previously discussed. It's possible no solution will appeal to all three.

Based on my experience and discussions with fellow practitioners, the only real solution to the retirement problem is economic. The plan described here addresses the entire firm's economic needs and the conflicting views of various partner groups. The solution is based on an idea developed by Eugene E. Kolasny and Susan Andersen, president and vice-president, respectively, of LaSalle Financial Group in Chicago. They developed the concept and created the proprietary software.

A New Client-Service Opportunity
As often is the case, good ideas, strategies and techniques that help CPA firms are equally applicable to other professional organizations. The partner retirement problems faced by law firms, for example, are almost identical to those faced by accounting firms. It would be a wonderful marketing strategy to be the first CPA firm in your market area to introduce the solution to partner retirement funding discussed in this article to the law firms you serve or would like to serve.

In general, the same opportunities exist for other types of professional practices as well, including doctors, dentists, engineers, architects, consultants and similar group-practice business organizations.

This article is not intended to analyze every nuance of the plan. While the plan's basic purpose—to prefund future retirement obligations with predictable, comparatively small affordable annual cash contributions and to ensure with certainty that payments will be made without putting a strain on current partners' distributable income—is not complex, the plan's supporting documentation is. The intent here is to educate CPAs up to the point where they can apply the principles, not to be able to construct a detailed plan.

Because this is not a tax article, a lengthy discussion of the plan's tax foundation is not included. However, a comprehensive in-depth tax opinion, setting forth the tax issues, conclusions—as paraphrased in this article—and support (code regulations, rulings and cases), was prepared for us by a Chicago law firm. It is available to readers on request.

Mechanics of the plan. The plan operates under some fairly simple principles.

  1. The firm creates a trust to be the owner and beneficiary of variable life insurance policies on each partner's life.
  2. Each partner is a trustee of the trust, except that no partner has any authority over any policy on his or her life; all decisions with respect to such policies are made by other partners, as trustees.
  3. Policy loans, withdrawals and death benefits (all tax-free) fund 100% of the required retirement payments.
  4. The terms of the retirement benefits are set forth in a buy/sell agreement or similar document among the firm, the partners and the trust. The agreement applies to a partner's lifetime retirement.
  5. Upon a partner's death, the trust (as beneficiary) collects the policy proceeds. The trust uses the tax-free proceeds for various purposes depending on current needs. It can repay bank loans and interest (see below), pay policy premiums and most important, pay retirement benefits to other partners.

Funding the plan . Funding comes from two sources: the firm, in the form of a fixed commitment to pay the same amount of money to the trust for a predetermined time, typically 20 to 30 years, and a bank loan to the firm, as necessary, to help meet operating costs. The loan is always fully secured by the insurance policies.

Income taxes . The tax law applicable to variable universal life insurance policies creates an income tax-free environment: earnings on invested policy funds (the cash surrender value) accumulate tax-free. The death-benefit "profit" (the difference between premiums paid on a policy and the policy proceeds) also is tax-free.

Estate taxes . The transaction is structured to allow the policy proceeds, which are payable to the trust, to escape estate taxes.

Payment of retirement benefits . The heart of the plan, the retirement benefits, comes entirely from the tax-free insurance policies. The payments (assuming a cash-basis taxpayer) are deductible by the firm as "guaranteed" payments and taxable as ordinary income to the retired partner. Guaranteed payments are payments to a partner who is no longer a member of the firm to the extent they are determined without regard to the partnership's income. (IRC sections 736(a) and 707(c))

Policy loans and withdrawals . This is the basic source of tax-free funds, supplemented by the eventual death benefits. The policy loans bear interest at a low rate. When the trust receives death benefits, it immediately uses part of the proceeds to repay policy loans. Withdrawals bear no interest and are never repaid.

The bank loan . In the long run, the loan is nothing but an exchange item: Money comes in as needed over a period of years to help the firm pay its operating expenses while it is funding the plan. The firm repays, also over a period of years, the exact amount that came in to fund the plan, to the bank (plus interest, of course). The same source of funds used to pay the retirement benefits—policy loans, withdrawals and death benefits—also is used to repay the loan. The loan is the catalyst that provides a firm with the financial leverage it needs to get the money compounding tax-free. Although each plan will vary, the lion's share of the retirement costs is paid via the loan as opposed to firm contributions.

The major outcome CPA firms can expect is an actuarially sound plan that creates a tax-advantaged way to prefund the firm's retirement obligations. The plan should relieve the problems inherent in a pay-as-you-go program and

  • Dramatically cut the aftertax cost of the firm's retirement obligation.
  • Create predictable cash flow because the funding obligation is preset.
  • Provide financial security for partners close to retirement.
  • Relieve younger partners of the burden of paying off a growing pool of retiring partners.
  • Serve as a recruiting aid for both new and experienced staff, as well as new partners.
  • Help with partner retention because of increased distributable income and a reasonable assurance of all retirement payments being received when due.
  • Result in an actual in-pocket gain in excess of both the completed retirement obligation and repayment of the loan, thus contributing to current distributable income. This excess also can be used to prefund benefits for the next round of new partners.
Case Study: The Plan in Practice
I am the retired partner of a firm that had a pay-as-you-go retirement plan. I was one of four partners who retired over a period of 10 years. While this was no problem for the firm, half of the remaining equity partners (we also have nonequity partners, but only equity partners receive significant retirement benefits) will retire over an eight-year period starting in the year 2000. Here is how changing from a pay-as-you-go plan to the plan described in this article is projected to help our firm.

The firm's commitment under the plan (to fully fund the current potential retirement liability for all current partners) is $62,500 per year for 25 years, for a total of $1,562,500. (The projections actually go to the year 2046.)

Here are the key numbers:  
Firm contributions $ 1,562,500
Bank loan (Repayment starts in 2011) 4,029,418
Policy loans and withdrawals 7,442,019
Death benefits 2,893,937
Total receipts $15,927,874
Less Disbursements  
Policy premium payments (stop in 2012) 3,046,331
Interest payments to bank 2,798,145*
Bank loan (Repaid in 2027) 4,029,418
Benefit payments 4,491,480*
Total disbursements $14,365,374
Balance returned to firm $ 1,562,500
* Net after 40% income tax deduction on gross amount.  
As you can see, the firm ultimately receives its total contributions ($1,562,500) back in full. The net cost of the plan in absolute dollars is zero. The only real cost is the time value of money, in this case, the $1,562,500. The projected pay-as-you go obligation, shown above as "benefit payments," is $4,491,480 in absolute dollars ($7,485,800 of aggregate payments by the firm to partners less income tax savings).

To get a broader perspective, here's another real-life example for a much larger firm. This firm is top-heavy, with a large percentage of partners nearing retirement. The firm's $32,304,000 aftertax retirement obligation to its partners can be reduced to $14,149,695 ($537,500 in annual firm contributions to the trust for 30 years).

Both of the above examples presume the need to borrow to pay operating expenses while the firm's cash is being used to fund the plan.

Firm split-up or merger . If a firm that has adopted this plan splits up, the trust would remain an asset of the firm. Trust assets would be divided among the partners in the same way as any other firm asset. Of course, any outstanding loans must be repaid first.

A merger creates three possibilities . (1) New partners would be added to the plan. This is the most likely scenario and might be a key reason for the merger. (2) The assets could be divided among the original partners as they would be if the firm split up. (3) Only the partners in the plan at the time of the merger would remain as participants, to the exclusion of the new merger partners. This is the least likely scenario.

Two important caveats . The plan described here does not work well if a large number of partners in the firm are uninsurable or represent substandard risks, which would raise premium costs. In addition, there is always a possibility that the short-term rates charged on the bank loan will be higher than the rates paid on the insurance policies. Since such a situation may be of short duration, the guaranteed policy loan provisions can be used to make up any shortfall. In the unlikely event the rate differences continue for an extended period, the cost of funding the plan would increase somewhat as the firm loses the leverage provided by the bank financing.

A number of factors have an impact on the plan's final cost. The most important are the age spread of the partners, the number of partners in the plan, the amount of the retirement liability and the firm's willingness to cut the future liability by current funding. The case study on page 60 shows how the plan works in practice. If your firm has, or will have, a partner retirement problem, you owe it to yourself to see how a plan like this one might solve the problem. Failure to do so could jeopardize the firm's financial stability and the hard-earned retirement of its partners.


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