Tax ups and downs when leaving a law partnership

If you are an equity partner leaving a partnership, there is a long list of items to factor in when you make your move. In this article, we concentrate on the general options which may be available. Next week, we will focus more specifically on tax considerations.

The key considerations of an outgoing equity partner are likely
to be:

• Will I have any ongoing liabilities?
• What is my profit share going to be in my final year?
• Will I be paid any goodwill?
• When will I be paid?
• What are my options for the future?
• What are the taxation implications?

These items may be governed by a partnership agreement, but many firms do not have enforceable agreements. In those cases, what should be done?

Ongoing liabilities
It is standard procedure for continuing partners to give indemnities to an outgoing partner. The indemnity should protect the ex-partner from any ongoing liabilities of the firm, even if the liability results from actions taken while he was still a partner. Legal advice should be taken, though, to ensure that this is the case.

It is important to be aware of claw-back provisions relating to limited liability partnerships. It may be possible to claw back amounts that have been withdrawn from a LLP within two years of liquidation.

It is also important to check that the bank will release the partner from any personal guarantees that may have been made in respect of partnership loans and overdrafts.

Profit share
Profit sharing is always a challenging topic, particularly where the overall profitability of firms may be falling. This can sometimes become confrontational and can be complicated still further if the partner leaves during, rather than at the end of, a financial year.

If a retirement is well planned the profit share can be agreed in advance and is often at a fixed level. But we have found that many partner departures have not been well planned and that profit-share disputes have arisen as a result.

It may be possible to agree a fixed profit share for the departing partner, although in our experience it is usually a percentage of the overall profits for that year or period. This sometimes complicates matters, particularly if the partner leaves during the year. In this case some firms have accounts prepared to the date of departure, which may have a cost implication. Others simply apply a percentage to the year-end results, assuming that profits have remained steady - something that might not currently be the case.

Care should be taken when approving profits for the final year, as there is a risk that the remaining partners would want to boost profits after the departure. They may attempt to do this by taking a more stringent view on the recoverability of debts or by providing for potential losses in the period of departure, for example.

A key influence on the profits for the year and the level of the current/capital account is the valuation of work in progress, or accrued income. There are disagreements within the accounting profession on the correct methods of recognising and valuing work in progress, and the valuation process is incredibly subjective - a book could be written on these topics.

We would always advocate that the calculation of profit and work in progress is in accordance with accounting standards. But as the valuation of work in progress can be so subjective, perhaps the real aim should really be to achieve consistency. If partners have agreed on valuation techniques in the past, they should have little ground on which to object to the same accounting policy in the year of a retiring partner. It may be worth engaging an external solicitor specialist accountant to help in correctly valuing the recoverable work in progress.

Since the introduction of Urgent Issues Task Force Abstract 40, non-contingent work in progress has essentially been valued at selling price and contingent work, in most cases, has not. If all work in progress, whether contingent or not, were to be valued at selling price, then the accounts would reflect a true value of work performed to date. In that case, a departing partner could walk away from a firm with their current and capital account and feel that they have been appropriately rewarded for work performed by the firm during their tenure.

But since not all work types are valued at selling price in the accounts, a partner may argue that their current account should be uplifted to reflect the value of work not recognised - essentially a goodwill payment.

Goodwill
Once again, a book could be written on whether or not to pay goodwill to retiring partners, whether or not to recognise goodwill on the balance sheet of the partnership, and if it is to be paid/recognised, how to value it.

What is goodwill? In these circumstances, goodwill is essentially any payment received over and above the value of a retiring partner's capital and current account. Generally, goodwill can be split into two types - internally generated goodwill and acquired goodwill. Accounting standards require acquired goodwill - an amount paid for another business over and above the fair value of the net assets of that business (on a merger, for example) - to be recognised on the balance sheet and then written off to the profit-and-loss account over a short number of years. According to accounting standards, internally generated goodwill should not be recognised on the balance sheet.

Although partnerships are required to compute their taxable profits in accordance with UK Generally Accepted Accounting Practice, they are not required to comply with the accounting standards in terms of accounting disclosure. Therefore, some partnerships argue that internally generated goodwill has a value and reflect this on the balance sheet as an asset of the business. This is particularly so when there is a set precedent for partners to pay for goodwill on entry to the partnership and receive a payment for that goodwill on departure. But most partnerships exclude it from their balance sheet, even if they accept that it has a value.

So, is there any goodwill, especially in the current climate?

It is fair to say that the value of most law firms has fallen in the downturn. Many firms with a significant exposure to conveyancing may have no goodwill at all, which may well cause the departure of a partner. The knock-on effects of the recession and decreased activity in the property market on other practice areas have been well documented. Therefore, it would be difficult to make a case for attributing goodwill to many high-street firms.

Still, there are still certain law firms that could argue that their value is greater than their net assets. These are likely to be larger firms - those with personal injury teams with unrecognised contingent assets and niche practices.

If the practice has goodwill, should this be paid to retiring partners?

Most firms do not recognise any goodwill even if they accept that it does have a value. Nothing is paid on becoming a partner and nothing is received on departure - 'born with nothing, die with nothing'. One of the main reasons for this is the impact on succession - it is easier to attract new partners if they do not need to contribute a large amount to pay outgoing partners' goodwill in addition to the capital that they are required to contribute.

However, many partners argue that they have built their practices up to what they are today and that they deserve to be paid a premium for doing so. This is more common with sole practitioners and small partnerships, which were established by those who are currently looking to leave.

Whether goodwill is paid to departing partners is often settled by precedence, if not by a partnership agreement. If a partner paid for goodwill on entering the partnership, they would expect to be paid on departure. It is not common for partners who paid on entry to accept no payment on departure simply for the future viability of the firm.

Payments
Repayments of partners' capital accounts on departure are usually covered by the partnership agreement. Often the capital will be repaid over a set number of months, typically ranging from 12 to 36 months. During this period, nominal interest is often
earned on monies left in the practice even if the ongoing partners do not benefit in such a manner.

Where this matter is not covered in the partnership agreement, or there is not a valid partnership agreement in place, it could be assumed that the capital should be repaid on departure. But ongoing partners will usually negotiate these terms with the departing partner with the ongoing cashflow demands of the business in mind.

Options open
Partners depart from partnerships for a wide variety of reasons, and the appropriate options available to them will vary depending on those reasons.

• Retirement: considerations will tend to focus around the sufficiency of any pension provision, particularly following recent market falls, and whether a full pension can and should be taken.
• Retirement as a partner, but maintaining a continuing role within the practice, perhaps as a consultant: considerations will include the expected hours; how payments will be based; expense payment terms; whether the consultant can also work elsewhere; and the taxation status of the consultant.
• Joining a new firm as either a partner or an employee: considerations will include the location, status and size of a potential practice and also whether the departure was caused by a downturn in demand for the work type that the partner previously performed - is it possible to retrain in a different work area?
• Setting up a new firm: a whole host of factors to consider will include the current state of the economy; the availability of finance for the new practice and for the ongoing personal demands of the partner; demand for the services that can be offered and potential sources of work.

In this article, we have only touched the surface in terms of the general implications of leaving a partnership. Each of these factors will need to be considered in great detail before making any firm decisions.

Andy Poole is the solicitor services director at Hawsons Chartered Accountants and the UK chairman of LegalPlus, an alliance of solicitor specialist accountants. Nicola Keene is a personal tax manager at Hawsons Chartered Accountants