A Practice Smart(TM) Feature*
By Jonathan M. McGee
Many attorneys lack an adequate business succession plan. Failure to plan for death, disability, divorce, retirement and termination can be critical mistakes for any business, including law firms. One of the most effective ways to address law firm succession planning is through the use of buy-sell agreements. However, there are some unique considerations that must be made with when implementing a buy-sell agreement in a contingency fee law practice.
A buy-sell agreement is an agreement between the owners of a business whereby those owners or the business may (or must) buy out the shares of an owner at a predetermined price upon the occurrence of a specific event. Buy-sell agreements can be used to address the non-desirable conduct of other partners, such as withdrawal, discharge, divorce, and bankruptcy, and they act as a powerful business succession planning tools in the event of death, disability or retirement.
Prior to implementing a buy-sell agreement for a contingency fee law firm, the partners must agree on the type of buy-sell agreement to utilize, what will constitute a triggering event, the valuation method used to determine the purchase price and the method for funding the purchase price.
Type of Agreement:
The type of buy-sell agreement utilized answers the question of “who” can or must purchase the partner’s interest. It is generally either the other partners or the firm, but it can also be a special purpose entity. This decision involves a number of factors, including the number of partners, whether life insurance can be obtained for each partner, the amount of disparity in premiums, analysis of tax issues and balancing of costs. The two most utilized types of buy-sell agreements are the cross-purchase agreement and the entity purchase agreement.
Cross-purchase agreements typically require each partner to take out a life insurance policy on each of the other partners. Upon a death or other triggering event, the remaining partners buy the deceased partner’s interest with the insurance policy proceeds. Cross-purchase agreements are more common and are usually preferred if there are only two or three partners. The primary drawbacks of a cross purchase agreement are that (i) the number of insurance policies required significantly increases as the number of partners increase, and (ii) younger and healthier partners will pay increased premiums on the policies for the older and less healthy partners. For many firms, the number of policies required for funding and the unequal cost burden are simply too big of a hurdle for implementation.
Entity Purchase Agreement:
Under an entity-purchase agreement, the entity owns the insurance policy and buys the partner’s interest upon the triggering event. Entity purchase agreement may be preferable where there are many partners or where there is a significant disparity in the ages or insurance premiums among the partners. With an entity purchase agreement, the business needs to purchase only one policy for each partner (as opposed to each partner having to purchase a policy for each other partner).1 However, entity-purchase agreements have significant disadvantages as compared to cross-purchase arrangements. Entity-purchase agreements do not confer the same step-up in basis that is received under cross-purchase agreements and entity-purchase agreements could cause the purchase price to be included in the estate of a partner who dies holding more than a 50% interest in the entity. Thus, the tax implications of an entity purchase agreement must be carefully reviewed with business partner.
Entity Cross-Purchase Agreement:
In recent years, the IRS accepted strategies that have the advantages of both cross-purchase and entity purchase agreements without their respective disadvantages.2 These entity cross-purchase agreements are designed as a traditional cross-purchase agreement, but they have a special purpose entity that owns and implements the buy-sell agreement. With an entity cross-purchase agreement, the partners execute a cross-purchase agreement and form an LLC taxed as a partnership to own the life insurance. The cross-purchase agreement and LLC operating agreement both have provisions that reference each other and then the LLC controls the payments and implements the buy-sell agreement. Under the entity cross-purchase agreement, only one insurance policy per owner is required, the premiums are divided equally between the partners and the shares passing to the surviving business partners will receive the stepped up cost basis for purchased shares.
The biggest drawback of the entity cross-purchase agreement is the additional costs associated with drafting the more complex entity cross-purchase agreement and the costs associated with creation of a new business entity to implement the buy-sell agreement. However, when there are three or more partners and the buy-out amount is likely to be significant, the entity cross-purchase agreement is generally superior to the traditional structures.
A triggering event is one that triggers the right or obligation to purchase the partnership interest of a partner. Death is almost always a triggering event, as are long-term incapacity, divorce and withdrawal. However, the valuation method, payment terms and even funding method will likely vary across these categories. For example, funding for a withdrawal may be valued using a method that will likely produce a lower value that the method used for death or incapacity. Likewise, the payment terms may be less favorable for those triggering events deemed to be less desirable. Defining what is and is not a triggering event is an important step in crafting an appropriate buy-sell agreement.
Perhaps the most difficult issue to address in a buy-sell agreement for a contingency fee law practice is the valuation method to be utilized. Valuation options include fair market value, fair value, formula pricing, book value, a stated price, capitalized earnings or a percentage of future cash receipts (wait and see approach). Fair market value tends to be the most appropriate in theory, but there are many ways to determine fair market value. Without very specific appraisal guidelines, determining fair market value can be costly, lengthy and contentious, particularly where multiple appraisers are involved. Moreover, in a contingency fee law practice, there can be drastic differences in the methods used to value contingency fee matters.3 The Hawaii Court of Appeals has taken steps to eliminate some of the discrepancies by offering its own 10-step approach to valuation of contingency fee matters.4
In order to avoid the complexity and potential arguments over a fair market value appraisal, some companies utilize a stated price which provides for a price certain and quick administration. However, for this option to properly work, the partners must actually agree upon a price at each periodic review interval. Consider adding language which would require a clearly defined fair market value appraisal if the stated price has not been updated within the provided review period.
If a fair market value appraisal will be utilized, the partners might consider meeting with one or more qualified appraisers before finalizing the buy-sell agreement. This meeting would allow the partners to discuss the various valuations options with the appraiser, obtain input on how to properly state the desired valuation methodology in the buy-sell agreement and, hopefully, select an appraiser to be named in the agreement. If an appraiser is not selected up front and clear valuation methodology is not set forth, a costly battle of the appraisers might ensue once the buy-sell agreement is triggered.
The purchase price for a buy-sell agreement can be paid in full or can be spread out with periodic payments over time. The time for payment of the purchase price could be 90 days or less so long as the triggering event is one that is funded by insurance. If the purchase price will not be funded with insurance, then a periodic payment may be desirable. Moreover, the terms of the purchase (including the amount) may vary widely based upon the nature triggering event.
For the contingency fee law practice, a lump sum payout may be appropriate in the event of death or incapacity. However, for other triggering events, it may be more appropriate to combine an initial lump sum payment based upon book value with an “earn-out” for open matters. While an earn-out might not be preferable for the estate of a deceased partner, it could be ideal for a retiring partner. Buy-sell agreements can be very flexible, particularly with regard to the payment terms for the various triggering events. Firms should specifically review each of the triggering events identified in the buy-sell agreement and ensure that the terms associated with each event are drafted to produce the most desirable outcome.
A buy-sell agreement will not be very effective if there is no money available to fund the purchase. A buyout under a buy-sell agreement will typically require a substantial outlay of funds – more than most companies have lying around in petty cash. Sources of money for a buyout payment can come from the firm’s retained earnings, establishment of a sinking fund, use of an installment type purchase agreement, a third-party loan or life insurance. However, acquiring funds to complete a buyout through borrowing or depleting cash reserves is risky and there is no guarantee these sources will be available at the time the buy-sell is triggered.
A majority of law firms will find that the most effective way to fund a buy-sell agreement will be with life insurance, either term or whole life coverage. Term coverage may be an inexpensive option for death and disability coverage. Cash values policies, however, will likely provide more meaningful coverage for a wide variety of triggering events. Such a policy could be a valuable source for buyout funding upon a partner’s death, disability, incapacity, and even retirement due to the cash value component.
For triggering events which are not covered by insurance, an installment type purchase agreement will typically be utilized. For a contingency fee law practice, this installment purchase will likely include an earn-out or similar method to capture a portion of future revenue as discussed above.
In summary, a proper buy-sell agreement will ensure that: (i) a partnership interest is promptly transferred pursuant to terms established by the firm, (ii) fair compensation is provided to the effected family, and (iii) ownership is transferred in such a way as to cause minimal disruption to the firm’s operations.
While most business owners, including attorneys, should have buy-sell agreements in place, many attorneys may defer implementation of a buy-sell agreement because of the cost, lack of time or perhaps the perceived tax disadvantages associated with an entity purchase agreement. However, the cost to implement a buy-sell agreement can be very low for a cross-purchase agreement between two or three partners and the time commitment can be as little as an hour or two for each partner. For larger contingency fee law firms, the tax implications of an entity purchase agreement can be minimized and the practical impediments of a cross-purchase agreement eliminated by utilizing the entity cross-purchase structure. Whether the firm is large or a small, a properly drafted buy-sell agreement will help address the various life events which may be experienced by the firm’s partners without causing significant setbacks to firm.Jonathan M. McGee, JD, CPA is an Estate Planning and Business Attorney and is the founder of the McGee Law Firm, LLC located in Scottsdale, Arizona. Mr. McGee is licensed to practice law in Arizona, California and Nevada. Mr. McGee is a native of Arizona and earned is Juris Doctor from Arizona State University where he was a member of the Arizona State Law Journal. For more information regarding Mr. McGee or the McGee Law Firm, please call (480) 729-6208 or visit www.mcgeelawaz.com.
1 For a firm of 5 partners, there would be a total of 20 individual insurance policies, whereas under an entity purchase agreement there would be only 5 policies.
2 See Internal Revenue Service Private Letter Ruling, PLR 200747002. See also Using a General Partnership to Structure and Fund Buy-Sell Arrangements, Journal of Financial Service Professionals (January 2000.
3 See In re Marriage of Restaino, 2012 Cal. App. Unpub. LEXIS 273 (Jan. 13, 2012); In re Marriage of Kingery, 2011 Okla. Civ. App. LEXIS 110 (Dec. 29, 2011); Rappaport v. Gelfand, 2011 WL 3215379 (Cal. App. 2 Dist.)(July 28, 2011);Weinberg v. Dickson-Weinberg, 2009 WL 3294784 (Hawai’i App.)(Oct. 14, 2009); and Von Hohn v. Von Hohn, 2008 WL 2814830 (Texas).
4 See Weinberg v. Dickson-Weinberg, 2009 WL 3294784 (Hawai’i App.)(Oct. 14, 2009) setting forth the following 10-step approach to valuation of contingency fee matters:
- Identify the outstanding cases at the valuation date.
- Estimate the average fee per case, net of direct expenses.
- Assess the success rate or “batting average” of the firm.
- Determine/estimate the percentage overhead per case.
- Multiply the number of open cases (step 1) by the net average fee per case (2) by the batting average (3) less the percentage overhead (4) to obtain the estimated future profit attributable to the WIP.
- Estimate the average length of time of open cases (i.e., compare the start date and recovery date for a number of cases).
- Calculate the estimated date of completion for each case by comparing its start date to the average length of the case (step 6).
- Select an appropriate discount rate to apply to the present value calculations.
- Determine the present value of the WIP by discounting the estimated future profit (step 5) by the discount rate (8) using the estimated completion date per case (6) as a time factor.
- Add the value of the WIP to the firm’s adjusted balance sheet, with additional adjustments for cash, investments, and other assets/expenses.
The information in this article is provide for informational purposes only and with the understanding that the author is not engaged in rendering legal, accounting, tax or other professional advice or services. The discussion is not intended as legal advice and cannot be relied on for any purpose without the services of a qualified professional.
*Practice SmartTM Features are a service of Michael Blum and Appeal Funding Partners, LLC. The Features are thoughts from a variety of sources on our practices, on being trial lawyers and things of importance to trial lawyers and their clients.
Michael Blum is a trial attorney and CEO of Appeal Funding Partners, LLC with over 17 experience easing the financial hardship and stress of attorneys and plaintiffs with money judgments on appeal. He has served on the Board of Directors of the Consumer Attorneys of California and of the Marin Trial Lawyers Association and is an active member of the American Association for Justice. He regularly speaks to trial-lawyer groups and has written for TLA publications on the financial management of a contingency-fee law firm. He may be contacted at 415-729-4214.
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