PASSING THE Baton.

Succession strategies for CPA Forms

You're too young. You're too busy. The estate tax is going to be repealed, so you'll wait.

Perhaps you're a procrastinator, or just downright uncomfortable with even the mention of succession planning as it represents a loss of control, mortality and myriad other issues. Whatever your reason for stalling, or even if you've started your succession plan, this article outlines many succession planning considerations for CPA firms and offers clarity on how to transfer your practice.

Transfer tax consequences, forced liquidation and business failures are among the dismal results of poor succession planning. In fact, failure to plan for a practice's transition usually results in the loss of the practice's entire value to the family. And since most experts agree that a full, permanent repeal of the estate tax under the new legislation is unlikely--there's no time like the present.

CPAs must not only be aware of ordinary succession planning issues that arise, such as saving transfer taxes and ensuring a smooth transition of their business interests, but they also must be well-versed in the rules imposed by California Business and Professions Code Sections 5000 et seq., that address who may own an interest in an accounting practice.

TYPES OF OWNERSHIP

An accounting practice's organizational form may limit who can receive the practice on the owner's death. Accountancy business owners generally hold their practices in the following forms:

Sole Proprietorship 

The simplest form of operating a business is a sole proprietorship.

There is only one owner, who holds the business' assets as his or her property. No entity is involved.

Accountancy Partnership

According to Business and Professions Code Sec. 5072, a partnership, other than a limited partnership, may be registered to engage in the practice of public accountancy, provided it meets certain requirements.

Business and Professions Code Sec. 5079 generally provides that a non-licensee may hold an interest in an accountancy firm, provided that such non-licensee holds only a minority interest, both voting and equity, and materially participates in the business of the firm. The Business and Professions Code defines material participation as an activity that is "regular, continuous, and substantial." Otherwise, there is little guidance from the California code, California Board of Accountancy, legislative history and regulations about what constitutes material participation.

For example, will transferring an owner's interest in an accountancy firm to a family member employed by the firm as support staff jeopardize the firm's public accountancy status? Probably not. Neither Business and Professions Code Sec. 5079 nor its regulations limit material participation to accountants.

While Business and Professions Code Sec. 5072 specifically disallows a limited partnership to be registered as an accountancy partnership, Corporations Code Sec. 16101(6)(A) specifically sanctions the use of limited liability accounting partnerships (subject to the provisions of the Business and Professions Code relating to who may be a partner). However, Sec. 16101(6)(A) generally requires that each of the partners be licensed. Thus, a transfer of an interest in a limited liability partnership generally should be made only to a person who is licensed.

Accountancy Corporation

An accountancy corporation is a corporation registered with the CBA, and which has a currently effective certificate of registration from the board pursuant to the Moscone-Knox Professional Corporation Act. Because Business and Professions Code Sec. 5079 applies to professional accountancy corporations (B&PC Sec. 5151), the same limitations on share ownership are imposed on professional accountancy corporations as those on accountancy partnerships (that is, a non-licensee may hold only a minority interest, both voting and equity, and must materially participate in the firm's business).

WHO SUCCEEDS TO THE BUSINESS

A deceased accountant's choices for disposing of his or her practice at death consist of the following: (i) transfer of the business to a family member involved in the business; (ii) transfer (sale) of the business to a co-owner or key employee; or (iii) transfer (sale) of the business to an unrelated third party.

Family Members Involved in the Business

If children or other close family members are engaged in the business, the owner may wish to cause the business to pass to them at death. This is because, in many cases, it maybe difficult for these individuals to find commensurate jobs outside the business, particularly if they are older and have devoted their full professional lives to the business.

Valuation is the issue here, especially if the business is being left to one child, with non-business assets left to other children. Instruction as to how value should be determined should be included in the accountant's will or trust to avoid family arguments.

Consider a formula clause (a multiple of gross/net earnings), or perhaps have the inheriting and non-inheriting children each choose an appraiser, with each appraiser then choosing a third appraiser and have the third appraiser's opinion control. Determine whether value should be adjusted for the inheriting child's "sweat equity"--to credit the child for his or her work efforts, perhaps the value should be adjusted downward by a set percentage (10 percent to 20 percent).

Transfers to Co-owners

In the absence of advance planning, if the practice is left to co-owners, conflict may develop between the surviving owners and the heirs. If the heirs are not active in the business, they may desire or need income from the business, but the active owners may not want to pay large amounts of income. For example, if the company is a C corporation, the other owners may draw large salaries from the business and have no need to distribute dividends, which would be subject to a double tax. Obviously, this would be troubling to the deceased owner's heirs. Also, the heirs may not be qualified under California public accountancy rules to hold an interest in the firm, thus jeopardizing the firm's public accountancy status.

To avoid this conflict, it is best to put in place an arrangement that requires the co-owner to buy the business from the deceased accountant's estate or trust. This leaves the co-owner free to operate the business without heirs' interference, and it leaves the heirs with the cash they need to support their lifestyles.

Types of Buy-Sell Agreements 

The type of buy-sell agreement employed depends on who the purchasers are. If the purchaser is the surviving co-owner, the agreement is referred to as a "cross-purchase" agreement. If the purchaser is the company, the agreement is referred to as a "redemption" agreement.

In a cross-purchase agreement, each co-owner owns insurance on the life of the other. When one co-owner dies, the other collects the insurance and uses the proceeds to buy the deceased co-owner's interest in the business from his or her estate or trust. No gain or loss is recognized on the sale because the estate/trust's interest in the business receives a basis equal to fair market value when the co-owner died. (If the estate tax is repealed, this basis step-up will be limited.) The surviving co-owner then owns the entire business.

In a redemption agreement, the company owns the insurance on both co-owners. On the death of an owner, the company uses the insurance proceeds to redeem the deceased owner's interest in the business from his or her estate/trust. Again, the basis step-up avoids gain recognition, and the surviving co-owner then owns 100 percent of the business.

Cross-purchase agreements are usually the better alternative, since the surviving owner receives basis for the amount paid to the deceased owner's heir for the deceased owner's interest. If a redemption agreement is used, the surviving co-owner does not receive basis. The primary advantage to a redemption agreement is the simplicity in having the entity own and pay for the insurance policies. However, in the cross-purchase agreement, the business can "bonus" the co-owners the amounts necessary (after taxes) to allow them to make the premium payments.

Installment Purchases

If neither the co-owner nor the business have sufficient cash to buy the deceased owner's interest in a lump-sum, an installment payout can be built into the buy-sell agreement. However, the installment approach leaves the deceased owner's heirs subject to the risks of a business now operated by the surviving co-owner--who may or may not be successful in running the business to make the installment payments. The heirs remain in a potential "conflict" position with the surviving co-owner until the installment payoff is complete. The business operated by the surviving co-owner is saddled with debt as well, limiting profitability for the surviving co-owner.

For all of these reasons, the deal should require at least a down payment equal to the anticipated estate taxes due. Even better, if the co-owners are insurable and the business can afford it, it's best to fund 100 percent of the buy-sell agreement with insurance.

If one of the co-owners is not insurable, other buyout methods should be used. Note also that insurance costs may be limited by using term insurance--only if the partners believe they'll be in business together for a limited term (usually no more than 20 years). If they think they'll be together forever, the term insurance won't work, it will become too expensive to maintain as the co-owners get older. In this case, more permanent insurance (i.e., universal life) should be used.

SALES TO KEY EMPLOYEES

Sales to key employees often make sense when the owner has no partners or children who are interested and qualified to assume ownership responsibilities.

The same buy-sell provisions for sales to co-owners may be used in a buy-sell agreement with a key employee. Alternatively, the business owner may transfer his or her interest to the key employee through an equity restructuring. This allows the owner to sell or transfer equity participating interests in the business to a key employee, but transfer management control separately as the owner gets more comfortable with the key employee's ability to make prudent management decisions.

USE OF REVOCABLE LIVING TRUSTS

Revocable trusts are used in most estate plans to avoid probate. This result is accomplished only if assets, including a person's interest in his or her accountancy practice, are transferred to the revocable trust during the settlor's lifetime.

Sole Proprietorship

Although California imposes strict limitations on when a trust may own stock or a partnership interest in an accountancy firm, these limitations do not apply to ownership of a sole proprietorship. This is because the sole proprietorship is made up solely of assets, such as equipment, leases, receivables and customer lists. Each asset, including the name of the accountancy practice, generally may be assigned to the revocable trust without limitation. However, on the owner's death, if the practice's assets are sold, the time frame during which the successor trustee takes action becomes critical.

The sole proprietorship's real asset is its goodwill--which usually includes the client list--although for tax purposes, goodwill and client lists are considered separate and distinct assets. Thus, as time passes, the deceased owner's former clients might engage other firms, and the client list would lose its value quickly.

If the successor trustee is the licensee owner's spouse, which is generally the case, he or she might be at a loss for how to go about valuing and selling the assets.

If the trust provides for the sale of assets, as opposed to distribution of the assets to a qualified family member to continue the business, the owner should consider naming, as successor trustee with respect to the assets, a trusted adviser who is capable of having the assets valued and sold with the least disruption to the business. Alternatively, the business owner may provide in the trust document who potential purchasers may be, if any, and who the successor trustee should consult in regard to selling the assets. It is probably not best to direct the trustee to provide a named purchaser an option (or "right of first refusal") to acquire the assets. If the option lasts too long, the assets' value may be lost if the named purchaser chooses not to exercise it.

Partnership or Stock Interest

The CBA has not taken a position on whether the transfer of an interest in an accountancy practice to a revocable living trust will jeopardize its qualification as a public accountancy firm. However, the California Department of Consumer Affairs, which is made up in part by the CBA, in a legal opinion (79-5, Feb. 16, 1979), appears to have sanctioned the ability to transfer a stock or partnership interest in a public accountancy firm to a revocable living trust under certain circumstances.

Legal Opinion 79-5 provides that to maintain public accountancy status, both the trustees and beneficiaries of the trust must be licensed individuals. (In California, a licensed accountant is a CPA, a public accountant or a CPA in good standing in another state.) Thus, when spouses jointly enter into a trust agreement and only one spouse is licensed, the trust instrument should specifically provide that the licensee spouse has exclusive control of the interest in the practice.

The non-licensed spouse may have an equitable title to the proceeds of the interest that is not greater than the community property interest that he or she already has. However, neither the non-licensed spouse nor a trust for his or her benefit may own an interest in the entity.

If the licensee spouse dies before the non-licensed spouse, the non-licensed spouse's interest generally would be distributed to a survivor's trust for his or her benefit, while the licensee spouse's interest would be segregated in the residual trust, consisting of assets constituting the deceased spouse's interest in community property, quasi-community property and separate property. The residual trust would then be divided into a marital and bypass trust.

A surviving non-licensed spouse may be the beneficiary of an interest in the proceeds from the practice solely because of his or her one-half community property interest (i.e., the portion set aside in the survivor's trust) after the licensee spouse's death. Therefore, the trustee should sell the interest and distribute the proceeds to the survivor's and residual trust.

If the non-licensed spouse dies before the licensee spouse, the licensee spouse, as trustee, will continue to hold legal title to the interest (usually in the survivor's trust). Without specific instructions in the trust instrument, the deceased non-licensed spouse's interest generally would be distributed to the marital or bypass trust. The surviving spouse (the licensee) is the sole beneficiary of the marital trust during his or her lifetime. The bypass trust may be for the benefit of the surviving spouse and their children.

If the surviving licensee spouse is trustee of the survivor's, marital and bypass trust, and is the sole beneficiary of each, public accountancy status for the entity will be preserved. However, if the bypass trust gives the trustee authority to make distributions to anyone other than the surviving spouse, unless such other person is licensed, the bypass trust would not be qualified to hold an interest in the entity under California law.

There are at least three ways to ensure that the entity will maintain its public accountancy status upon the non-licensed spouse's death. First, if the trust instrument permits payments from the bypass trust to individuals other than the surviving spouse, those other individuals might disclaim their interests within nine months of the deceased spouse's death. This can result in the bypass trust being solely for the licensee spouse's benefit, and therefore qualify the bypass trust as a permitted holder of the entity.

Alternatively, the trust instrument could provide that, on the death of the non-licensed spouse, the non-licensed spouse's interest in the accounting practice is to be distributed to the marital trust, which is, by definition, solely for the benefit of the surviving licensee spouse.

A third option is to make the trust instrument provide that the survivor's trust be funded with the entire interest in the entity owning the practice, and a distribution of additional property may be made to the bypass or marital trusts to "equalize" the distribution of the entity to the survivor's trust. For either of these last two alternatives, it is important that the trust instrument allow for both pro rata and non-pro rata distribution of trust assets.

If the owner instead wants to distribute his or her interest to a licensed family member, but is not comfortable that the family member is qualified to manage the business, the trust could call for the interest to be set aside and held in separate trust for the family member's benefit. The trustee would have to be a trusted friend or adviser who is a licensee, such as a co-owner of the business, and the trust would give the trustee discretion to distribute the interest to the family member when the trustee believes that he or she is responsible enough to handle the ownership interest prudently. Alternatively, the trust may provide for certain thresholds that, if satisfied, would cause distribution of the interest to the family member.

POST-DEATH REQUIREMENTS

Regardless of whether the business owner's heirs are to dissolve the accountancy practice or sell the deceased owner's interest, when the owner dies holding a partnership interest or shares of an accountancy practice, the CBA should be notified within a month of the owner's death. Though not set forth in the Business and Professions Code, it is good practice to notify the firm's clients of the owner's death, and give them an opportunity to retrieve their files if they intend to transfer their business.

If the owner's heirs intend to transfer the owner's interest to another person, the CBA generally will allow the business to continue for a reasonable period after it's notified of the owner's death. This would not be the case if the owner of the decedent's interest is the estate or trust, either of which would likely be unlicensed and unqualified to hold interests in the practice.

If the decedent was the business' sole owner, the remaining work may be performed by a staff accountant who worked for the business, or by another CPA who the deceased owner's estate or trust engages to perform the work. In either case, returns would have to be signed by the CPA individually, and not on behalf of the deceased owner's business entity.

Transfer to Family Members During Lifetime

In addition to installment sales, several tools may be used to transfer the owner's business interest to a family member during the owner's lifetime. Transferring during life reduces potential estate taxes due at death. Three such tools are the private annuity, grantor-retained annuity trust (GRAT), and the preferred stock recapitalization.

When considering these options, the private annuity sale should be used only for an owner not expected to live to his or her life expectancy. The CRAT and preferred stock recapitalization only should be used when the business' value is expected to appreciate after the transfer.

NAME OF THE PRACTICE

Business and Professions Code Sec. 5060 significantly liberalized the rules regarding what names may be used in an accountancy practice. In general, all that is required is that the name not be "false or misleading." Thus, a purchaser of an interest in an accountancy practice is not required to change the firm's name, even if it's the predecessor owner's name. This is a matter of negotiation between the estate and the individuals buying the practice.

CPAS must give careful thought to how their accountancy practice will pass at death. Careful planning makes it possible to avoid conflicts between co-owners and heirs, provide liquidity to heirs, maximize the practice's value and avoid probate.

Andrew M. Katzenstein, Esq. Is a partner in the Los Angeles and Palo Alto offices of the law firm, Katten Muchin Zavis.

David P. Schwartz, Esq. is an associate in Katten Muchin Zavis' Los Angeles office.