A case for automatic haircuts to deferred partner compensation

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Leading a CPA firm is analogous to herding cats — impossible to do and yet try we must!

There’s no doubt about it. Leading and governing partners in small and mid-sized CPA firms, at times, can be very daunting tasks for managing partners.

Most partners in small and mid-sized CPA firms respect and comply with the provisions in their partnership agreement. Unfortunately, almost every firm has a number of partners (usually high-performing partners who are also high-maintenance partners) who either interpret partnership agreement provisions in a way that benefits them in some way or, worse yet, choose to ignore these provisions altogether. As a result, it takes a strong-willed managing partner to enforce many aspects of the partnership agreement. If the managing partner isn’t strong-willed, the high-performing, high-maintenance partners will certainly push back and that’s when some ugly discussions inevitably take place.

Three interrelated partnership agreement provisions can often create conflict between management and certain partners:

  • Partners must give the firm two years notice before their contemplated retirement date. This is usually baked into a partnership agreement to allow the firm adequate time to transfer client relationships to succeeding partners.
  • During the two-year retirement notice period, partners have the responsibility to transfer client and referral relationships to new client service partners — most of the time to younger partners who need to build a client list.
  • The firm provides deferred partner compensation arrangements that have been earned because partners were good soldiers over many years of service. To some degree, earning that deferred compensation comes when partners provide timely notice of retirement (which is particularly important when a partner chooses to retire before the mandatory retirement age) and client relationships transition to the next generation. But if you ask those high-performing, high-maintenance partners about deferred compensation arrangements, they will say these payments are entitlements and the partners are due whatever the partnership agreement calls for. No ifs, ands or buts!

Therein lies the rub. Individual partner motives get questioned when retirement notice isn’t provided on a timely basis, or client and referral relationships aren’t transitioned in a timely manner. In these circumstances, firms get squeezed into action and, as a result, clients aren’t always successfully retained and transferred to the next generation post-retirement. Is this what the noncompliant partner wanted to happen in the first place? Did the noncompliant partner want to hold onto the client and referral relationships so they can be moved to a new employer if the partner decides the grass is greener at another firm?

Isn’t insanity defined as doing the same thing over and over again and expecting a different result? Of course it is, yet this scenario repeats itself over and over again at many small and mid-sized CPA firms, and nothing much is done to deal with the management challenge. Leaders at many firms are not strong willed in enforcing the provisions of their partnership agreement. It’s almost as if managing partners are throwing up their hands and falling into the trap of accepting that the loss of clients and referral sources is inevitable as partners retire. While some clients might want to seek a new firm when their client service partner retires, there are things that can be done to avoid the loss of many. Firms should implement a process to reduce the likelihood of nonadherence to these provisions in the partnership agreement. If all else fails, partnership agreements be amended to include “enforcement teeth” or penalties to these provisions.

Here’s what I suggest. Every managing partner (or member of the executive committee) should meet quarterly with their partners to review progress toward goals established at the beginning of each year. For partners who are 55 years of age or older, the initial meeting should include a reminder that proper notice is due the firm within two years of retirement, the establishment of a planned timeline for transferring client and referral relationships to the next generation and, last but certainly not least, a discussion about setting expectations for the retiring partner that they will receive reduced compensation when compared to the peak years as their individual contribution to firm profits will be reduced during the final two years of employment.

At each subsequent quarterly meeting with the retiring partner, a discussion should be had involving progress in transferring client and referral relationships in accordance with the plan. If these relationship transfers are being made in accordance with plan, that’s great. If, on the other hand, client and referral relationship transfers are not being made in accordance with plan, the partner should be reminded of their responsibilities. Hopefully this gentle reminder will create sufficient activity and relationship transfers begin to get back to plan.

The partnership agreement should be amended to include language clearly stipulating that noncompliance with timely retirement notice and failure to timely transition client and referral relationships in accordance with an agreed-upon timeline can result in two annual automatic reductions (or “haircuts”) to otherwise earned deferred compensation of up to 5 percent each. The discretion to exercise this provision is in the hands of the firm’s executive committee. A reduction of up to 10 percent of a deferred compensation amount is not trivial and hits a noncompliant partner right in the wallet where it really hurts. This deterrent, when all else fails, usually cures much of the nonadherence.

Remember the old TV commercials by Smith Barney: “We make money the old-fashioned way. We earn it.” Well, the same is true with deferred partner compensation. It is earned. It is not an entitlement. I strongly believe that if a retiring partner doesn’t adhere to the provisions of a partnership agreement (when it comes to providing retirement notice and transfer of client and referral relationships), that partner hasn’t, at least in part, earned it. If not earned, the firm’s executive committee should be able to exercise its discretion in giving a “haircut” to the deferred compensation payments. To avoid such an ugly occurrence, a process can be put in place that usually creates an environment of better partner compliance.

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Partnership agreement Succession planning Practice management Partnerships Dom Esposito