Succession Planning for Professional Service Firms

By Baker Newman Noyes January 1, 2016

Professional service firms generally start small—a one-person practice, perhaps—and then add people and routines that eventually define the culture of the firm. Often without careful deliberation, the relationships between the people in the firm become entrenched, and eventually a need arises to describe those relationships in documents of increasing formality. Sooner or later, things like an Operating Agreement (or By-laws), Employment Agreements, Buy-Sell Agreements, Deferred Compensation Agreements and Qualified Plan documents will fill the members’ filing cabinets. Somewhere along the way, the professionals or their advisors will wake up to the fact that these basic building blocks will govern how the firm will evolve over the rest of its life.

When we speak of “succession” in the context of professional service firms, we might be contemplating anything from the sale of a solo architect’s practice to a merger of international accounting firms. The fundamental income tax issues in these transactions are essentially the same. With the exception of most tax credits and a few statutory deductions that are not based on cash outlays (percentage depletion, for example), all income tax planning involves manipulation of either timing or tax rates. “Timing” refers to when the tax on income becomes payable (later is better). The reference to “tax rates” usually addresses whether certain income is eligible to be taxed as long-term capital gain or at some other lower-than-ordinary rate. It also applies to the increased effective tax rate that exists in the sale of assets by a corporate entity other than an S corporation. The tools used to optimize the timing and tax rates incident to a transaction will vary depending on how the original owners laid out the firm’s DNA. In the following discussion, we will explore the alternatives available to various types of firms.

Although every firm probably has some unique feature, all firms likely are taxed as one of the following:

• A “C” corporation (“C Corp”). A C Corp is a corporation chartered under state law that has not elected to be taxed as an S Corp. Because we are focused on professional practices, a C Corp is probably also a “personal services corporation” (“PSC”), which means that it pays Federal taxes on all of its taxable income at the highest corporate tax rate.
• An “S” corporation (“S Corp”). An S Corp is legally identical to a C Corp. For income tax purposes, an S Corp has filed an election to have its shareholders account for its taxable income and deductions.
• A partnership. Although legally quite different from one another, for purposes of this discussion, the term “partnership” refers to general partnerships, limited partnerships, limited liability companies (“LLC’s”) and (in some states) Professional Limited Liability Companies (“PLLC’s). While all but general partnerships are chartered under state law, none is considered a tax-paying entity. Like S Corps, partnerships “pass through” their income and deductions to their owners.
• A sole proprietorship—a one-person operation, which might have employees but not co-owners.

Funding of transaction – who is really paying?

Before diving into a detailed analysis of the implications of entity choice, we should recognize another essential component of a firm’s DNA, and that is the expected source of funding for succession transactions. Generally, there will be some expectation that a successor will be either an “internal” buyer, or an outsider. A young professional might have joined a solo practice as an employee with the hope of becoming a partner with the founder and eventually becoming the sole owner. Or a group of physicians may have resisted the admission of new owners with the expectation that another firm would come along and pay cash to buy the practice. Typically with “inside” deals, there is an understanding that in some manner the firm itself will provide the funding. That manner is critically important to the economics and tax structure of the succession.

To illustrate the concept, let’s assume a lawyer practices in her 100%-owned S Corp with gross revenues of $250,000. After paying a salary to one young associate/heir apparent and all other expenses, the net income is $ 75,000, which the lawyer takes out of the practice as salary. An oversimplified model values the practice at 1 times revenue, or $250,000. The lawyer and her associate have agreed that the lawyer will be paid $25,000 per year for ten years, at the end of which the associate will own the practice. Here are a few of the many remaining questions that will determine the structure of the deal:

• Who is the buyer?
• When will the payments begin? When will the lawyer stop practicing?
• If the buyer is the S Corp, will it continue to pay the lawyer $75,000 per year for her services?
• What is the corporation acquiring in exchange for the payments? Stock? Intangible assets? Services?
• Does the S Corp have a qualified retirement plan, and would distributions from the plan count towards the $25,000 per year purchase payments?

The primary economic issue raised by these questions is whether the buyer or the seller is paying for the practice. If the consideration will be coming from earnings that the seller would otherwise keep, the seller might just as well work until she drops. On the other hand, the buyer might have the resources to add new money to the mixture, or the parties may anticipate that the seller will work less, so that it really is the effort of the buyer that generates the funds to pay to the seller. It is common to characterize some of the payments to the seller as compensation, so at least to that extent it is customary for the seller to pay his or her own way.

Regardless of the choice of entity, almost every succession plan involves some form of deferred payments and some form of continuing compensation to the seller. Buyers, sellers and their advisors should be careful to understand how much of the overall consideration is intended to pay for the seller’s actual services, how much to pay for rent on assets retained by the seller, and how much to pay for the practice itself. This should be a two-step process. The first step is identifying what the real values are; the second step is characterizing (allocating) the various payments for tax purposes.

Tax impact and planning

In most “inside” succession plans, it is likely that the practice will earn the funds necessary to pay the seller. The real question is how the taxes on those earnings will be paid. In the foregoing example, if the seller has been withdrawing the S Corp’s earnings regularly, she has accumulated little basis in her stock of the corporation. If the agreement is that she will withdraw earnings for a few more years and then sell her shares to the buyer for a note (and a few more years of the firm’s earnings), she will pay ordinary income taxes (high rates) until she sells the stock, and then capital gain taxes (lower rates) on the note principal (plus ordinary tax on the interest). Once the stock is owned by the buyer, the firm’s income will be taxable to the buyer, while the principal payments (essentially the same earnings, now redirected to the seller as principal payments) will be taxed to the seller. This points out another difficulty of the “inside” stock deal—the principal payments are being taxed twice, albeit some (the seller’s portion) at lower rates.

Given the simplicity of the example, it is likely that this succession transaction should be structured as a sale of stock coupled with some amount of continuing compensation to the seller. To the extent that the buyer achieves current deductions for compensation (or rent or interest) paid to the seller, the buyer will be assisted by the tax benefits associated with the deductions, and therefore might be able to pay more in total for the practice. Of course the converse is also true—if the seller insists on a greater allocation to the stock sale (because gain on the stock sale would be taxed at lower capital gain rates), the buyer might be able to pay relatively less in total because there is less tax help from current deductions. In this situation, there is a well-recognized tension between the parties, and it is likely necessary to model the transaction to determine the actual effect of the purchase price allocation on the parties’ respective after-tax results.

In a professional practice, the tension between the buyer and seller over tax advantages is probably inevitable. Because payments for stock of a corporation (whether C or S) are not currently deductible, most buyers will have a strong preference for acquiring the assets of the practice rather than stock of the corporation that owns the assets. What are the assets that can be assigned value in a purchase, and what is the tax significance of the allocation? Except in some medical and dental practices, there generally are no significant physical assets needed to conduct the practice, so that leaves intangibles such as accounts receivable, work in process, and “goodwill.” From a seller’s vantage point, allocation of the total price to accounts receivable and work in process yields the worst possible result (ordinary income with no basis). The buyer, on the other hand, will likely enjoy an immediate deduction of the same amount (the best possible result).

As long as the practice is not housed in a C corporation, some middle ground might be found by allocating the purchase price to intangible assets such as goodwill or customer/client lists (so-called “Section 197 intangibles.”) If the Section 197 intangibles were not initially purchased by the seller and depreciated, the sale of them should be taxed as capital gain. Although not immediately deductible by the buyer, Section 197 assures that the buyer will be allowed an amortization deduction over time. In theory, during a period of low interest rates, a stream of annual deductions is not worth significantly less than an immediate deduction, (although there is an obvious difference in cash flow).

If the practice is housed in a C corporation, there is the additional problem of taxability at the corporate level. Gain recognized on the sale of assets will either be taxed, or will need to be sheltered by deductible payments to the corporation’s shareholders. This problem can become more difficult to solve as the size of the practice increases. For example, consider the sale of a mid-size medical practice that has $ 5 million of untaxed accounts receivable. If the acquiring firm pays cash to acquire the receivables, the selling corporation will incur tax on the entire $ 5 million, unless it can pay the money out to the shareholders in a form that is deductible. The logical form of payment would be compensation, but the amount could be considered unreasonable. (A complete discussion of the deductibility of such payments is beyond the scope of this article, but suffice it to say that the deduction cannot be assured.) To have any chance of eliminating the tax on the $ 5 million, the corporation would have to disburse the entire amount in the year of the transaction. If a subsequent audit (likely two or more years after the money was paid out) results in a disallowance of the deduction and a resulting tax liability, the corporation would have to find the cash needed to pay the tax. (Retaining some of the sale proceeds as a reserve for the tax liability is not an option, because all of the cash was needed to create the deduction.)

Size is a vitally important factor in designing a succession transaction. The tax risks associated with purchase price allocations usually arise because the taxing authorities might consider the absolute amounts to be “unreasonable,” and hence not deductible. For example, if a transaction calls for salary-continuation payments to the sole seller, the deduction of such payments will probably not be questioned if they bear some relationship to the seller’s recent earnings. On the other hand, if the seller is a five-partner law firm with ten associates, the total transaction size might be large enough to draw the taxing authorities’ attention to the individual partners’ ongoing salaries—particularly if some do not continue to work.

Most of the aforementioned difficulties are easily avoided if the practice is conducted by an entity that the tax law classifies as a partnership. That is primarily the result of statutory provisions that allow a partnership to deduct payments to retired partners irrespective of a “reasonableness” standard, and that allow the partnership (or purchasers of partnership interests) to recognize any premium paid for a partnership interest in the basis of the partnership’s assets. For instance, assume that the entity’s governing documents (LLC Agreement, By-laws, Partnership Agreement, etc.) state that the firm will pay a departing partner an amount equal to the partner’s average earnings from the firm over the prior five years, and that such payment will be treated as a payment in liquidation of the partner’s interest in the partnership. Section 736(a)(2) of the Internal Revenue Code says that such a payment is treated as a “guaranteed payment,” which in most cases means that it will be ordinary income to the recipient, and a current deduction to the other partners.

Separately, the law says that the sale of an interest in a partnership is generally treated as the sale of a capital asset (subject to recharacterization in several important respects), very like stock in a C Corp or S Corp. However, the law also says that if a seller realizes a gain on the sale of a partnership interest, the partnership can elect to increase the tax basis of its assets by the amount of the seller’s gain, thereby gaining additional deductions for the other partners. Although the mechanics for calculating and allocating the tax benefits of this basis step-up are complicated, the flexibility afforded by these so-called “Section 754 adjustments” makes it far easier to optimize the tax results of a succession when the seller is treated as a partnership.

Conclusion

So what conclusions can be drawn from this discussion?

1. Perhaps the most valuable characteristic that can be chosen for a new practice is flexibility. At the inception of a small practice, it may not make much difference whether the entity chosen is a partnership, LLC or corporation. As the practice grows, however, it not only becomes more difficult to change the entity to something else, the adverse consequences of a bad choice also become more severe.
2. Although C Corps were once the entities of choice for professional practices for compelling reasons, that is no longer the case. Practices in C Corps should explore opportunities to change as soon as it appears that the practice is on a healthy growth trajectory.
3. Size matters. It is easier to structure a tax-favored succession of a smaller practice than a larger one. This is not only because a larger practice will have more parties with diverse interests and goals; it is also because allocations to the most tax-favored attributes become more difficult as the absolute dollar amounts increase.
4. The after-tax consequences of a succession transaction are especially susceptible to the structure of the deal. Not only should the parties understand the drivers of the value of various components, they should also understand how the structure can lead to differences in the timing and applicable tax rates.

There is an entirely natural and inevitable conflict between the interests of buyers and sellers in structuring a transaction involving the succession of a professional practice.  In most cases, a format can be found that will yield a fair after-tax result to both sides, but it may take years of planning and preparation. The successful parties will benefit from having a team of experienced advisors help them through the negotiation of the deal.

If you have any questions regarding the tax and related ramifications of succession planning, please contact your Baker Newman Noyes advisor at 800.244.7444.