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Looking ahead: too often, CPAs ignore their own succession planning advice.

It's a sad, but true fact: most CPAs treat succession planning for their own practices the same way the cobblers treat their barefoot children: While they advise clients of the importance of succession planning for their businesses, far too many CPAs have ignored their own advice for their own practices.

In fact, only 20 percent of firms facing succession issues in the next five years have addressed these issues, according to a recent AICPA survey.

And as more CPAs near retirement age, they are realizing that they haven't planned how to convert one of their most valuable assets into cash. Further, CPAs who fail to plan in advance and start trying to sell their practice in the year they want to retire are often dissatisfied with the results.

This article provides an overview of the succession planning process and discusses issues that CPAs must address.

BEGIN AT THE BEGINNING

Your clients often ask you how early they need to start planning for the sale of their businesses and how to prepare their businesses for sale. You respond that planning for the sale or disposition of the business should occur at the time the business is formed, when the type of entity for the business is chosen. This same advice applies to a CPA's practice.

You advise your clients that very few buyers want to buy a business' stock, preferring buying assets to minimize their exposure to the selling entity's potential liabilities and to gain tax advantages. The same wisdom applies to accounting practices. What buyer wants to purchase the stock of an accountancy corporation and assume liability for claims against the selling entity, such as malpractice or employment-based claims?

Thus, as part of this early planning, CPAs setting up a practice should consider organizing it as an S corp or LLP to facilitate asset sales, maximize flexibility and avoid adverse tax consequences.

At least three years before any planned sale, the selling firm should start preparing for the buyer's due diligence. Careful buyers will review books and records, malpractice claims history, client files, financial information, retirement plans, practice policies and procedures, and all contracts, including leases, employment agreements and policy manuals, to identify and correct any possible issues and problems.

IMPORTANCE OF DUE DILIGENCE

Due diligence often occurs after the buyer and seller have agreed upon price and payment terms. The buyer will then conduct its due diligence to ensure that there are no problems or issues with the purchased practice that will result in liability to the purchaser or a decrease in the value of the purchased practice.

However, a secondary purpose for many buyers is to discover problems that can be used to negotiate price reductions. This is similar to the situation that occurs with many house purchases, where a price is agreed upon, and then the buyer has the house inspected and asks for concessions, credits or a price reduction based upon "defects" discovered during the inspection.

Many sellers will conduct due diligence on their own practices in advance of a sale, including reviewing contracts to determine if they are assignable, financial records to ensure there are no conditions that a buyer will find undesirable, the malpractice or employee claims history, and that all policies and procedures are in accordance with laws and standards of practice.

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Even if the buyer is not assuming any of these liabilities, to the extent that they might taint the practice, the buyer can and will use these problems to negotiate a price reduction or, in the extreme situation, withdraw from the transaction.

INADEQUATE DUE DILIGENCE #1

Let's consider the impact of inadequate due diligence from the buyer's perspective to understand why buyers treat this as so important. Hypothetically, assume that an accounting firm acquired another firm with an audit practice. Assume further that there were deficiencies in the audit procedures significant enough to result in malpractice claims against the selling firm, which the buyer could have discovered if it had conducted an in-depth review of the audit files of the target firm.

While the acquiring firm might not be liable for these claims, if the staff of the acquired firm remained with the acquiring firm, the clients might feel sufficient dissatisfaction to switch from the acquiring firm to another accounting firm, thereby reducing the ultimate purchase price.

To make matters worse, assume that the audited client had a high profile in a sensitive industry. If these audit deficiencies become public knowledge, the impact on the reputation of the involved firms could cause other clients to change CPAs, including existing clients of the acquiring firm, not just those of the acquired firm.

INADEQUATE DUE DILIGENCE #2

Many buyers want to retain the name (branding) of the acquired firm to increase client retention. Hypothetically, assume that a tax preparation practice that was sold engaged in improper practices and procedures--such as encouraging clients to take a particular tax position that was very aggressive and/or wasn't adequately supported by the law or claiming unsubstantiated tax deductions. These actions, if discovered by the IRS, could result in all returns on which the selling firm is shown as preparer being targeted for examination.

If the purchasing firm retains or uses the selling firm's name, this could result in all returns for the purchasing firm's clients being examined as well, with obvious consequences.

As a result of these risks, purchasing firms often will carefully examine client files to minimize their exposure. Sellers should examine their own files before the practice is offered for sale, and resolve any issues found.

While client files have been used for these examples, these same principles apply to all items that might be examined by a purchaser during due diligence.

PRIMARY SUCCESSION METHODS

There are two main succession methods for accounting practices: internal and external.

Internal succession involves transferring ownership of the practice to other CPAs working for the firm, be it another partner, shareholder or staff members. External succession is the sale of the practice to another practitioner or firm not affiliated with the selling practice.

Internal succession requires that the firm employ qualified staff who are ready, willing and able to purchase and continue to operate the practice. Proper grooming of staff members is crucial.

This grooming must begin far in advance of an anticipated transfer. Staff members need to be given the opportunity to assume more duties and act more "partner like" to ensure that they are capable of becoming a successful owner of the practice, which in turn increases the likelihood that the seller will receive the full purchase price from a successful buyer.

External succession requires that the firm be attractive to prospective purchasers. Some questions to think about include:

* What makes your firm unique, valuable and profitable?

* Does your firm have a unique niche?

* Do you have clients for whom another firm could provide additional services?

* Will your clients (and employees) remain with this new firm or change once you have retired?

* Are the buyer's values, culture and professionalism consistent with yours, so that your clients and employees will remain? Remember, if your clients and employees don't remain, you are not likely to receive the full purchase price.

TERMS OF THE DEAL

The terms of the transaction and structure, including tax implications, are major issues for buyers and sellers. While each transaction is unique, certain patterns do exist.

Most selling prices are based on the selling firm's revenue. In many cases, the purchase price varies based on client retention and is a percentage of collections from clients of the selling firm over a three to five-year period after the sale. The seller and buyer thus become informal partners, both benefiting from, and thereby working for, maximum client retention.

The selling CPA often will remain employed by the purchaser for a transition period, which can range from a few months to as long as three to five years.

Tax planning is a major part of these transactions. Will the purchaser be paying with pre-tax dollars, which means that the seller will receive ordinary income? Will the purchase price for assets be made to the seller's C corp, thereby resulting in income that is subject to double taxation? Will the seller provide a covenant not to compete, with the result that payments will be taxable to the seller when received, but amortized by the purchaser over a period of 15 years? Will the individual CPA sell their personal goodwill, which may be taxable to the selling CPA as capital gain and amortized by the buyer over 15 years?

All of these issues will have to be considered and negotiated.

Succession planning is complex and must be considered far in advance of an anticipated transaction to ensure that the maximum value is received. While planning and negotiating a transaction, plan on having two full-time jobs: the normal running of your practice and its sale or transfer.

The following are some steps that accountants should consider in preparing their practices for succession. These and other topics will be addressed in future issues of California CPA:

* Realize that the firm must be prepared in advance for the succession and convince all partners of the need for preparation.

* If internal succession is appropriate, consider implementing procedures that will help retain and develop staff. Be sure there is an appropriate buy-sell agreement in place, if there are currently multiple partners, to ensure continuity of the firm.

* If external succession is appropriate, determine which of your firm's qualities could be attractive to buyers and expand them.

* Start evaluating your firm with an eye toward the buyer's due diligence and resolve any problem areas.

* Consider the likely terms of a transaction, which will require the retention of clients, and determine how this can be maximized to optimize the ultimate purchase price.

A CPA's practice is one of their most valuable assets. But few CPAs optimize that asset's sales price--and facilitate a smooth transaction--by engaging in advance planning for its succession.

You've put it off long enough--start looking ahead today.

Jonathan A. Karp, CPA, Esq. is a shareholder of Los Angeles-based law firm Reish, Luftman, Reicher & Cohen. He has chaired and spoken at numerous California CPA Education Foundation programs, including the Succession Planning for the CPA Firm Conference. He is co-chair of the Management of an Accounting Practice Committee for CalCPA's Los Angeles Chapter and has served as vice president and board member of the chapter. You can reach him at (310) 478-5656 or jonkarp@reish.com.

BY JONATHAN A. KARP, CPA, ESQ.
COPYRIGHT 2006 California Society of Certified Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:SUCCESSIONPLANNING
Author:Karp, Jonathan A.
Publication:California CPA
Date:Jun 1, 2006
Words:1749
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