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Unfunded obligations are off-balance sheet liabilities
to departed partners secured by contract. In professional
corporations they generally take the form of deferred
compensation so they are deductible to the firm.
Rationale
Unfunded obligations (UOs) are created for a variety
of reasons:
- To reward founders and early partners for the entrepreneurial
risk and investment in starting and growing the firm.
- To reward departing partners for the value of WIP
and AR left with the firm (offset by working capital
initially required until the lawyer became economically
viable when joining the firm).
- To provide a source of income in retirement, especially
in the era before tax deferred retirement funding
schemes became available, with time to build a meaningful
retirement fund.
- To give retiring partners reason to help ensure
the ongoing success and survival of the firm after
their departure.
Altman Weil survey data shows that fewer firms today
have such arrangements than five or ten years ago, fewer
than even three years ago. About 28 percent of firms
participating in Altman Weil’s 2002 survey have
such an arrangement. UOs are quantified in a number
of ways, based on AR and WIP at date of retirement,
compensation points. Final average earnings formulae,
or ongoing revenues from the partner’s clients
after retirement.
Impact on the Firm
The move to reduce or eliminate UOs comes from the
economic burden on the “surviving” partners,
as UOs are paid from then-current earnings of the firm,
reducing partner incomes. UOs have caused some firms
to dissolve rather than carry this burden. They also
make merger difficult where the other firm does not
have such an obligation.
Firms with a UO seek to reduce the one-year impact
of the UO by “capping” the amount of UO
payments in any given year to a percentage of either
gross fee revenues (typically one to two percent) or
net income (typically three to six percent). The delicate
balancing act is to establish an UO which is bearable
by the firm so its receipt is reasonably assured to
the departed partner ¾ i.e., not so burdensome
as to cause partners to withdraw or the firm to collapse.
Reducing/ Eliminating the UO
Many firms in recent years have reduced or eliminated
altogether the UO. Generally that requires sacrifice
on the part of individual partners who may view the
UO as a contractual obligation on which they are relying
as part of their retirement income. This issue is more
sensitive the more senior the partner, so it is always
best to address it sooner rather than later.
Reduction/ Elimination of the UO
Law firms in recent years have employed many schemes
to reduce or eliminate the UO. They include:
- Use of life insurance with cash values applied
to offset the UO, or to reimburse the firm for the
UO previously paid to the partner on death, or to
transfer to the retiree in place of his/ her UO.
- Use of annuities to fund the projected UO, even
though the premiums are not deductible.
- Use of “rabbi trusts” as a funding
vehicle.
- Considering “excess profits” (e.g.,
partner incomes in excess of 120 percent of prior
year incomes, for example) as offsets against UOs
ultimately due.
- Offsetting UOs by firm contributions (or a percentage
of them) to tax-deferred retirement plans (401k’s,
defined contribution plans, etc.), even though it
is arguably the partner’s “own money”
used for such a purpose.
- “Grandfathering” more senior partners
and cutting off the UO entirely for more junior partners
(easier where there is an age gap).
- Diminishing the benefit over time ¾ e.g.
100 percent of UO to partners retiring in the next
two years, 75 percent in two to five years, 50 percent
in five to ten years, etc.
The method selected will depend on the specific circumstances
of the firm ¾ burden, amounts involved, economics,
demographics, sources of tax-deferred retirement funds,
etc. The key to reducing this burden is to obtain universal
understanding of the issue and reasonable concessions
by partners for the long term good of the firm, or even
for its survival. In recent years some firms have chosen
to recast their UO as a deciding percentage of fees
received from clients of the retired partner, providing
an incentive for partners to transition their client
relationships so that clients remain with the firm.
Top
Ward Bower is a principal of Altman
Weil, Inc. He heads consulting assignments in law firm
organization, strategic and partnership planning, mergers
and compensation-related issues. He has consulted to
leading law firms throughout the world. Contact Mr.
Bower at wbower@altmanweil.com.
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