The importance of partnership agreements.

Every successful CPA firm should have policies for addressing major practice issues.

The preparation and periodic review of a CPA firm's partnership agreement is critical to practice success. A properly drafted and comprehensive agreement that is updated regularly can prevent or minimize many problems that otherwise might arise as the practice develops.

Because a partnership is intimately involved with the partners' personalities, no two partnerships are exactly the same. Thus, no model partnership agreement can cover the many concerns, goals and management styles and practices of every accounting practice. Nevertheless, all partnership agreements should address certain matters.

STATEMENT OF PURPOSES

Although the statement of purposes may seem to be a rather straightforward provision, it is important the agreement set forth the specific businesses in which the partnership will engage.

Because the scope of accounting practices has expanded over the years, many agreements should be amended to encompass the resulting changes. Today, most accounting partnerships include business consulting as an integral part of their practices, along with traditional services. Other practice areas may include recruiting, outplacement, litigation support and business valuation. Because the risks involved in each of these areas are not the same, it is important for each partner to understand and support the businesses in which the partnership will engage. Considering each partner's significant potential liabilities for partnership services, each must fully understand the risks he or she is undertaking by becoming or remaining a partner and by agreeing to the firm's involvement in various practice areas.

Outside business activities should be specifically prohibited unless approved by a partner vote. Outside opportunities, such as investments in the firm's real estate or other business ventures, might best be made through separate partnerships in which partners may or may not choose to participate.

NONCOMPETITION

Probably one of the most difficult provisions to negotiate, as well as to enforce, is a noncompetition provision. Two time periods must be considered when drafting them: the partner's tenure in the partnership and the period afterward.

The agreement should specify each partner's obligations to bring all business opportunities to the partnership and refrain from diverting partnership business to his or her own account. It also may describe situations in which a partner can engage in an economic activity for his or her own benefit, such as adjunct teaching. Even in these circumstances, however, the agreement should include some guidance to prevent partners from devoting excessive time to outside activities.

The more problematical provisions are those that restrict partners from competing with the partnership after they leave it. Restrictions may differ, depending on the nature of the termination. For example, stricter noncompetition provisions may apply in a voluntary termination than in retirement.

Enforcement of these types of provisions is difficult and most courts will not prevent an individual from earning a wage. An absolute noncompetition clause must be drafted carefully to cover a reasonable time period and geographic area. If a court determines the time period is too long or the geographic area too large, it will not enforce the provision; courts rarely alter provisions to make them enforceable. A partnership may have better luck enforcing a provision that deters a partner from taking partnership clients, but the client has the right to decide who is to act as its accountant.

Nevertheless, a departing partner can be required to provide a notice of withdrawal a specified period of time beforehand and may be prohibited from contacting clients before notifying the partnership so the firm can contact its clients to retain their business.

Another option is required forfeiture of any termination or retirement payment if a withdrawing partner violates the nonsolicitation or noncompetition provisions. Although it ultimately may be impossible to enforce a noncompetition or nonsolicitation provision, it generally is recognized that retirement or other termination payments can be conditioned on the partner's not competing with the partnership or soliciting its clients.

CAPITAL CONTRIBUTIONS

Partners frequently either lend or contribute money to the partnership. Although it is not always easy to distinguish between debt and equity, the distinction does not result in significant differences in tax treatment, so the issue has not been a crucial one for many partnerships.

Between the two ends of the partner debt-equity spectrum are numerous variations that focus on repayment terms and the interim charge for the use of funds. The documentation for all of these arrangements may be included either in the partnership agreement or in the form of an independent loan contract and promissory note.

When partners make equity contributions to the firm, the tax allocation and partnership distribution sections of the partnership agreement should ensure a proper priority return to the contributing partner and proper capital account maintenance. Care must be taken in drafting priority return provisions if the priority return to the partner is to be the equivalent of an interest charge and not merely an accelerated return of his or her initial capital contribution.

The form of a partner's economic contribution generally is determined by considering the partner's share in partnership profits, his or her management rights and what he or she brings to the partnership. In determining the partnership's debt-equity structure, it is helpful to try to articulate an underlying theory or philosophy for a partner's economic participation in the partnership.

For example, assume that a partnership has been structured so that each partner has one vote on all management determinations made at the partnership level, but the partners' respective profit shares fluctuate over time. The partnership agreement can require that each partner, regardless of his or her profit share in any given year, contribute an equal capital amount or it may stipulate that the capital structure be modified each year to reflect each partner's share of profits for that year. A middle position would be to require equal capital but to pay interest on this contribution.

The partners also should agree on their own obligations to the firm for future capital. In addressing this issue, a distinction must be made between partners' potential liability to outside creditors and to themselves. A partnership agreement is ineffective for limiting partners' liability to outsiders, but it can provide some protection for their capital contributions to the partnership. It also should cover partners' required capital infusions, setting maximum and minimum amounts that partners must contribute to keep a troubled firm in business.

It is not uncommon for a partnership agreement to contain a deficit restoration obligation requiring partners to pay off any deficit capital account balance on partnership liquidation. The money is paid first to outside creditors and then to other partners with positive capital account balances. Since the tax and other consequences of these restorations are complex, the details of any partnership agreement provision for them are beyond the scope of this article. This type of provision should be approached with care and with full understanding of the possible additional capital requirements that it might impose.

PARTNER CHANGES

A partnership agreement must address the numerous issues raised by the inevitable changes caused by disability, death, retirement or the admission of new partners.

Professional partnership agreements typically contain a general restriction on any voluntary partner withdrawal, except in the case of normal retirement. Any attempt to violate these restrictions usually is deemed a breach of the agreement and addressed by discounting the withdrawing partner's redemption amount and allowing the partnership to deduct any monetary damages caused by the withdrawal.

The admission of new partners usually is subject to a majority or supermajority partnership vote. Frequently, the partnership agreement sets forth requirements for partnership, such as professional qualifications and memberships or a certain level of client billings.

A partner's death, disability or retirement generally triggers redemption procedures that provide for the determination of a payout to the partner or his or her heirs. It's critical to formulate a procedure for determining disability and to clarify when voluntary retirement is allowed and when involuntary retirement is required.

Paying a lump-sum redemption amount can be a hardship for a partnership. The partnership agreement might stipulate an extended payout schedule or the purchase of life insurance for each partner. Such insurance must be acquired with care, since the manner in which the insurance is held can affect the tax treatment of payments.

PARTNER EXPULSION 

Expelling a partner is an unpleasant circumstance that must be addressed by any professional partnership agreement to avoid protracted and often acrimonious disputes. The provision should address expulsion for cause as well as without cause.

Among the bases for cause that an agreement might list are loss of a professional license and professional or other misconduct deemed prejudicial to the best interests of the partnership. Since the last two are more subjective than objective, there should be a procedure detailing how expulsion will occur. For example, a standing or specially appointed committee may be required to investigate the partner's conduct and make a recommendation to a management committee or the partnership as a whole. The management committee can be given authority for the final determination, or the decision might be referred to the full partnership. The agreement should specify what type of partnership vote is required and whether the vote is per capita or weighted on some basis, such as partners' varying capital contributions.

Expulsion also may occur because of personal bankruptcy, failure to make required capital contributions or failure to meet designated minimums in hours worked or billed or billings to clients. The procedures in these circumstances should be set forth in detail so there are no uncertainties or surprises.

In some cases, personality conflicts, differences in goals or work habits or other problems may lead a majority of the partners to conclude that all parties would be better served if one partner was terminated. When provisions covering such possibilities are included in the agreement, each partner knows where he or she stands and what is required for expulsion. The agreement should specify a set amount or formulary termination payment to be made to expelled partners.

TAX CONSIDERATIONS

Since the primary tax characteristic of a partnership is its flow-through nature, it is not surprising that a significant portion of any partnership agreement deals with allocation of business tax incidents among the partners. The Internal Revenue Co e requires that such allocations, if set forth in a partnership agreement, manifest substantial economic effect.

As a general rule, this means a partnership agreement must meet these three conditions:

1. Each partner has a capital account that is maintained so that all allocations of partnership tax items are reflected properly.

2. Distributions to the partners on partnership liquidation and termination are made in accordance with the capital account balances.

3. Any partner with a capital account deficit on partnership liquidation is required to restore it. If the partners are uncomfortable with the deficit restoration obligation, Treasury regulations section 1.704-1(b)(2)(2ii)(d) provides an alternative structure.

Drafting a partnership agreement to comply with these requirements can be relatively straightforward or enormously complex. The degree of complexity generally is a function of whether the partnership will incur nonrecourse debt and whether there will be partner contributions of appreciated property. Provisions for these events can be somewhat overwhelming and one of the most difficult planning decisions in drafting a partnership agreement is to determine their necessity. A typical agreement for a service partnership would forgo them, but the partners should be aware that the unexpected occurrence of either such event would require an amendment to the agreement to ensure proper tax treatment.

If these provisions are excluded, the partnership agreement can forgo numerous provisions otherwise required for assuring compliance with the substantial economic effect requirements. However, it nevertheless should contain detailed provisions on capital account maintenance and, if the partners want to avoid a deficit restoration obligation, it also should contain an appropriate stop-loss provision and the necessary qualified income offset.

PROFIT SHARING 

Probably the most difficult provisions to negotiate are those determining how partners share profits. There are numerous variations, and this is one area in which no particular provision or mechanism is uniformly advisable for all CPA firms. Rather, the partners must determine what works best for them by examining not only the nature of their business but also the partners' attitudes toward profit sharing and business development.

No matter what the partnership's choice, the agreement should specify the factors to be used in determining profitsharing allocations, the mechanism for applying them and how precise share amounts are to be decided and, if necessary, disputed.

MANAGEMENT PROVISIONS

An agreement's approach to partnership management depends largely on the size of the partnership. For example, an agreement for a two-person partnership may provide merely for joint decisions in ill cases. However, it is unusual and impractical even in the smallest partnerships to have all partners involved in everyday practice management. Consequently, most agreements provide for the designation of a managing partner and delineate his or her rights, responsibilities and, in some circumstances, compensation.

The partnership agreement must provide a method for designating a managing partner. It typically contains a broad delegation of authority for him or her, but it also should specify which decisions are reserved for the partnership as a whole. The agreement can require a full partnership vote on certain matters and can specify what decisions should be reached by a simple majority and which by a supermajority.

A CPA firm partnership agreement also should designate certain rights and responsibilities for each partner. For example, many such agreements say each partner has the right or responsibility to accept clients, incur incidental expenses in connection with his or her professional activities, perform tasks that are a part of the profession (such as preparing audit letters and other opinions), prepare client bills and maintain professional certifications. It may outline specific review procedures to be followed for audit letters and other official firm position statements.

DISSOLUTION

The partnership agreement should allow for dissolution by a partner vote and should specify the procedure to be followed and the exact vote required.

A dissolution provision also might set a specified partnership termination date, describe an event that would make it impracticable or illegal to continue or determine that the failure to reach certain performance levels would trigger termination. The agreement also should specify how the partnership's assets are to be liquidated and distributed.

In addition, the dissolution provision should provide for client files and similar records. Some partners may join other partnerships, form new ones or become sole practitioners and will need client files to continue servicing their clients. Further, future access to transferred files may be necessary if a claim is made against the dissolved partnership. Therefore, provision should be made for the transfer and preservation of client files.

GREATER AWARENESS

This discussion of the major terms of professional partnership agreements doesn't provide any specific language to be included in such agreements. Rather, it is intended to increase the reader's awareness of the importance of partnership agreements and what should be considered when partners prepare or review them.

EXECUTIVE SUMMARY

* A COMPREHENSIVE partnership agreement that is updated regularly can prevent or minimize many problems that otherwise might arise as a CPA practice develops.

* SINCE NO TWO partnerships are alike, no model agreement can cover the many concerns, goals and management styles and practices of every firm. Nevertheless, all partnership agreements should address certain matters, including

1. The firm's statement of purposes.

2. Noncompetition.

3. Capital contributions.

4. Partner changes.

5. Partner expulsion.

6. Tax considerations.

7. Profit sharing.

8. Management provisions.

9. Dissolution.

* GREATER AWARENESS OF A partnership agreement's importance and necessary provisions will enable firms to meet everyday challenges and address issues before they become problems.

THOMAS THORNE-THOMSEN, JD, LLM, is a partner of Keck, Mahin & Cate, a Chicago law firm. He is a member of the American Bar Association and the Colorado, Georgia and Illinois bars. JOHN B. TRUSKOWSKI, CPA, JD, is a partner of Keck, Mahin & Cate, Chicago. A member of the ABA tax section and the Chicago bar, he serves on the state and local taxes committee of the Illinois State Society of CPAs.