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PREPPREP

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SCHOOLracticing law and running a successful legal business—these are separate skills.

Attorneys interested in having their own firms need to balance variousproblems and objectives. What concepts need to be addressed?

• Business organization (form)• Tax• Compensation• Risk management

When you open your firm, these issues must be confronted, either by you—the attorney—or by outside professionals.

Change is inevitable. Why not prepare your firm with a buy-sellagreement? Here are some tips to getyou started...

BY ERIC DOWNING

SCHOOL

P

Choosing the OrganizationFirst, attorneys must select which form of organization is most suitable for their circumstances—for exam-ple, sole proprietorship, partnership or professional corporation. Each form has advantages and disadvan-tages relative to the desired tax treatment, compensation options and risk management choices. These con-siderations go beyond the scope of this discussion. Here, we focus on strategies that provide for businesscontinuation in the event of unforeseen occurrences.

Small law firms typically are owned and managed by a small number of attorneys. These owners areusually vital to the success of the enterprise. The loss of one of these individuals—through death, disabil-ity or retirement—may have a devastating impact on their families, business partners and the businessitself.

We all have heard the saying that “Doctors are the worst patients.” I believe that we could coin a newexpression: “Lawyers are the worst at conducting their own legal affairs.” Why? My experience is that it isa function of time, or the lack thereof. The attorney/business owner does not generate revenue from hisor her personal legal work. Therefore, it becomes a secondary consideration. Furthermore, though theymay be excellent attorneys, they may know little about business organizations, tax or risk management.

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ments. In addition, under EthicalRules 1.6/1.7 of the Arizona Rules ofProfessional Conduct, firms cannotdisclose “confidential” information fortheir own benefit; that includes a pro-hibition on disclosure to a bank of afirm’s accounts receivable that identifyclients (Formal Op. 92-04, Mar. 26,1992). A firm cannot disclose confi-dential information to obtain a line ofcredit for the firm without client con-sent.

3. Property or Stock in AnotherCorporation

4. Stock of the Buying CorporationRelative to property and/or stock

transfers, there are special considerationsfor a law firm. Ethical Rule 5.4 discussesthe fact that nonlawyers cannot have anyequity interest in a law firm. This prohibi-tion means that firms cannot sell interestsin the firm to nonlawyers (including non-lawyer employees of the firm), issue stockor otherwise sell investments in the firm.

The only exception is provided forspouses of the deceased lawyer regardingthe deceased lawyer’s equity interest. Inaddition, finding a buyer on short noticemay introduce a discounted liquidationprice below what is deemed acceptable.

Based on the underlying challenges, aswell as the ethical considerations, manywould agree that purchasing life insuranceto “fund” the plan is the best option.

Choosing a Buy–Sell AgreementThere are two types of buy–sell agree-ments:1. Cross Purchase Agreement: An

agreement between individual partnersin which each surviving partner agreesto buy interest from the estate of thedeceased partner on a pro rata basis

2. Entity (or Stock Redemption)Purchase Agreement: An agreementin which the partnership/corporationbuys the interest of the deceased part-ner and the surviving partners receivean increased percentage of ownership.The entity purchase agreement is usual-

ly recommended if there are a larger num-ber of partners. It is simpler, and fewertransactions are necessary when several

Preparing Your Firm for ChangeI am always surprised by the number ofpartnerships and professional corporationsthat have not executed a written“Buy–Sell” agreement. When asked why,lawyers provide typical responses:• “We have all discussed it and know how

we would handle it.”• “We bought life insurance for that.”

Both of these responses are steps in theright direction. Yet the key thing is to haveproperly drafted an agreement while allparties are alive and have “equal bargainingpower.”

Why now? Because the buy–sell agree-ment may be jeopardized if the value isdetermined post mortem and the partiesinvolved have unequal bargaining powerand conflicting goals. Furthermore, tryexplaining to the deceased partner’s spousethat all parties verbally agreed to a planthat the spouse believes to be inadequate.

Elements of the AgreementA properly drafted buy–sell agreement is amethod of ensuring that the deceased part-ner’s interest will be purchased by the part-nership/corporation. Second, it is a bind-ing agreement that the decedent’s estate isrequired to sell the interest to the survivingpartners. The agreement also shouldinclude the purchase price and/or the for-mula for determining the price.

Consideration also needs to be given towhether it will be a “funded” or an“unfunded” arrangement. There are fourbasic types of payment:1. Cash: The uncertainty of the event

puts pressure on the ability to accumu-late adequate cash reserves, presentinga challenge for this option.

2. Installment Payments: An installmentsale from current revenue would putadditional economic pressure on thefirm, because the installment paymentswould decrease the cash flow necessaryto operate the business. This mightforce the firm to borrow the money,which could put the firm in an unde-sired credit position and place strainon the firm to meet the monthly obli-gations of principal and interest pay-

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partners are involved.

ValuationThe Internal Revenue Service specifies thatbusiness valuation is to be at fair marketvalue (FMV). FMV is defined as theamount a willing purchaser would pay awilling seller, neither being under compul-sion to buy and sell and both havingknowledge of all relevant facts.

Business valuation methods fall intotwo basic categories: (1) focus on assets(2) focus on earning powers. The bookvalue method is the result of subtractingtotal liabilities from total assets of the busi-ness. In a service-oriented enterprise, bookvalue is rarely an adequate valuation.However, the balance sheet for the busi-ness is a good starting point. Real estate,equipment and accounts receivable areexamples of items to be included in thevaluation of the firm’s assets.

“Goodwill” represents the business’searning power in excess of a fair return onthe business’s tangible assets. However, alaw firm has unique restrictions as it relatesto using goodwill in its valuation. EthicalRules 7.1(j), 1.5(e) and 1.7 prohibit alawyer from selling the “goodwill” of a lawfirm because it constitutes an impermissi-ble referral fee (Formal Op. 92-08);Arizona has not adopted the ABA’s ModelRule 1.17 on the Sale of a Law Practice.

Practically speaking, the reputation ofthe firm’s name and/or a niche marketmay possess significant value; thus theimportance of a written, inter vivos agree-ment that establishes the value for thefirm. The IRS typically accepts formulavaluations.

There are two basic types of valuationmethods for earnings. The Capitalization-of-Earnings method is the most commonmethod for a small to medium-sized firm.It is an estimation of future earnings basedon past earnings, calculated on a presentvalue basis. The IRS recommends a five-year period. The Discounted-Future-Earnings Method is a more complex varia-tion of the capitalization-of-earningsmethod.

Our experience in the past has beenthat a “Combination Method” has worked

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best for the valuation of law firms. Thismethod establishes an FMV for the firm asa going concern, based upon past andpresent financial position, general econom-ic conditions, book value and special con-siderations. It is the capitalization of earn-ings (five years times the average annualearnings), plus book value.

Insuring Against LossThe buy–sell agreement is primarilydesigned to provide for the heirs of thedeceased partner. But what about the eco-nomic loss to the firm?

“Key Employee” risk exists where theloss of income (to the firm) or additionalexpenses would result from the death of anemployee. The first characteristic of a keyemployee is where that individual possess-es a specialized skill critical to the successof the firm. Second, he or she has a signif-icant client base and/or the responsibilityfor attracting large amounts of business tothe firm. Finally, their loss would damagethe credit rating for the firm.

Once again, the firm could purchase lifeinsurance on the key employee to coverthe risk of income loss and/or increase inexpenses that would result from the deathof that employee. You might considerusing “permanent” life insurance (thosetypes of contracts that possess cash values),for two reasons.

First, if the key employee (typically oneof the partners) survives to retirement, thecash values can be used to fund a deferred-compensation retirement plan. Rememberthat the values in these contracts accumu-late tax-deferred, and there are favorable

tax strategies when it comes time to spendthe money. These plans are called nonqual-ified retirement plans and are completelydiscriminatory. Second, an ancillary benefitis that at retirement, the policy could betransferred to the retiring partner for per-sonal estate liquidity.

DisabilityThe final dimension to business continua-tion planning is addressing the impact ofone of the partners becoming disabled dueto an accident, illness and/or injury. Long-term disability of a business owner is moredamaging to business yet less insured thanpremature death. Less than 20 percent ofthe U.S. work force is covered by long-term disability income protection, whereasmore than 80 percent of U.S. householdshave at least one member who owns lifeinsurance. Yet the risk of disability is high-

er than the risk of premature death. In fact,if two 35-year-olds remain partners for 30years, statistics indicate a 75 percent prob-ability that one will sustain a long-term dis-ability. And the average disability that laststhree months will continue for more thanfive years.

There are adverse effects of disability onthe disabled partner. First, there is the lossof income. Many are of the mindset thatthe firm would continue the disabled part-ner’s salary. In the absence of advancedplanning, this would present two conflicts.Would the firm want to continue payingfor any person who was not productive andcontributing to the success and revenue ofthe firm? And the IRS also has denied cor-porate deductions of salary payments todisabled employees. The payments aredeemed unreasonable compensation andhave been treated as nondeductible divi-

It is essential to providefor an orderly distribu-tion whereby the firm’s

continued existence isassured for the benefit

of the survivingpartners and family.

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dends and taxed to the recipient as ordi-nary income. Finally, the disabled partnerwill be holding a substantial asset (owner-ship interest) that may not be readily con-verted to cash.

The solution is to plan for this occur-rence in the buy–sell agreement and toadopt a Salary Continuation Plan. Incometo the disabled partner can be providedthrough disability income insurance poli-cies. Firm payments for premiums aredeductible (similar to health insuranceguidelines). It is recommended that thesecontracts have an expanded definition ofdisability to include some form of “ownoccupation” definition. This provision canguarantee benefits if the insured cannotreturn to a specialized career (i.e., practic-ing law).

There are also situations in which pur-chasing Business Overhead Expense con-tracts are useful. These contracts cover theoffice expenses (rent, utilities, employeesalaries, equipment costs, utilities, etc.)during a period of disability (but these

contracts do not provide income for thedisabled owner). The final considerationwould be some form of Disability Buy-Outcontract. These contracts provide a lump-sum payment to the firm for the purposeof purchasing the disabled partner’s inter-est.

ConclusionPlanning for the continuation of the smallto medium-sized law firm can be complex.Yet it is essential to provide for an orderlydistribution whereby the firm’s continuedexistence is assured for the benefit of thesurviving partners and their families.Prudent planning ensures that the familyof the deceased/disabled partner is prop-erly provided for, which is always the desireof the surviving partners.

In the absence of a comprehensiveunderstanding in this area, it is recom-mended that you involve competent pro-fessionals to assist you in the creation ofthis type of plan. The “team” approachusually works the best. A corporate attor-

ney is needed to draft the legal documents.A certified public accountant can be help-ful in the valuation process (or an apprais-er who is familiar with valuing law firms).The final member of the team should be acertified financial planner. This profession-al is essential in helping you to evaluate thedifferent programs that are available and todetermine which of the alternatives aresuitable for your situation.

But take note: Ethical Rules 1.7/1.8state that lawyers cannot accept referralfees from financial planners for referringlegal clients to the planner—this would bea conflict of interest (Formal Op. 98-09,Nov. 1998).

Eric Downing is the President of FinancialCounsel For the Legal Profession, a consult-ing firm that works exclusively with lawyersand law firms. He entered his career in 1986and became a Certified Financial Plannerin 1992. He can be reached at 602-241-8677.