Recession forces change in practice structures
Peter Garry of Cripps Harries Hall LLP explains how adopting a new practice structure can help accountancy firms weather the ‘boom and bust’ economic cycle.
Although many accountancy and other professional practices have converted to an LLP structure, most have retained the model of full distribution of annual profit. While some practices still adhere to valuation and sale of goodwill on retirement, this appears to be on the wane in the accountancy profession.
Elsewhere, for example in the solicitors’ profession, it has all but disappeared. However, the current economic climate may give rise to a radical reconsideration of the most prevalent business models across the professions.
In these difficult times many, if not most, professional firms and LLPs are asking their partners/principals to stump up more capital due to the fact that traditional sources of funding (i.e. the practice’s bank) may not be willing to lend. If it is, additional security may be required and the rate of interest on existing and new borrowing may be increased.
In the case of an LLP, banks prefer to lend to the principals rather than the practice (and some cases they might insist on this). Under most existing capital loan agreements the terms will be quite favourable to the principals, with interest often just a shade above the bank base rate and often with no security required other than an agreement by the practice to repay the bank rather than the principal.
In practices where interest on capital is paid (particularly in practices where the principals’ capital contribution is not equal), the interest rate payable has commonly been set at a level designed to produce a small ‘profit’ for principals who have borrowed from the practice’s bank. However, some principals who wish to borrow capital in the current climate may have to resort to lenders other than the practice’s bank, and additional lending (even if it is from the practice’s bank) may now be on less favourable terms.
This means that the traditional advantageous correlation between the rate paid by principals to the bank and the rate by the practice to the principals may disappear. Some principals (especially those who have been newly appointed) now have to raise capital for the first time and may be at risk of having to pay considerably more interest to the bank on their capital than the practice is prepared to pay them in respect of that capital.
Retention of profits
In order to avoid a renegotiation with the bank in respect of current borrowings or start making a loss on their capital, principals seeking to raise additional capital may decide to forego distribution of profits from the previous year that have not yet been distributed, or to repay all or part of the last tranches of profit that they have already received and convert those funds into capital instead. In effect, profits will have been retained, but from a tax perspective those retained profits will have borne tax at the highest possible rate.
In the limited company model, such profits would have been retained in the company and have borne tax at the lower corporate rate for retained profits. Many professional practices have, for good reason, shied away from the corporate model. Put simply, whilst retention of profits in a company is tax efficient, the extraction of funds from a company on a periodic basis for income purposes, or on a sale, may be tax inefficient when compared to a partnership or LLP vehicle.
A few professional practices are adopting a hybrid structure, for example by using the usual LLP model but with an additional limited company member (which is itself owned by the other members), which may well carry on a defined role within the LLP’s overall business. Within such a structure, profits for distribution can be paid to the individual members, whilst profits for retention can be paid to the corporate member, which can then lend them to the LLP. More money is available for the company to lend owing to the lower tax charge on the company’s share of (retained) profits.
Tax practitioners reading this article will know that there must a genuine partnership and that without care in the running of the LLP, a charge to tax under section 419 ICTA 1988 could arise.
Many existing professional practices may not wish to adopt such structures, even on conversion to LLP, perhaps for the sake of simplicity, a lack of commercial justification, or for reasons of overhead control, internal politics and/or reluctance to institutionalise the concept of profit retention. However, such structures should be considered as an option, especially for start-up practices.
Sharing the benefits
As capital increases and makes up an ever greater proportion of profits (which may fall alarmingly in the current climate), and as principals’ pension funds continue to be decimated through exposure to markets (not to mention the last Budget), principals may wish to look forward to better times and a proper return on their redoubled efforts. Some may wish to enjoy capital growth in line with the return enjoyed by shareholding principals of practices who have attracted external capital (either by floating or through private equity), once there is economic recovery and a resurgence in markets (and in the case of the solicitors’ profession, once the Legal Services Act comes fully into effect). Many retiring principals may be thinking ‘I’ve contributed to the growth of this business and now I’m giving it away for nothing’.
Managing boards and committees of non-externally capitalised practices may have to find ways to motivate their colleagues and themselves in a manner that is more attractive than the current reality of decreasing drawings, decreasing return on capital (which may be less than the cost of borrowing and/or lower than the rate of inflation), and on retirement relinquishing whatever is left.
In these circumstances, it remains to be seen whether accountancy and other professional practices will revert to the goodwill purchase and sale model and/or adopt a corporate or quasi-corporate model, virtual share or other goodwill valuation scheme, but for those with confidence in the future such structures might be an attractive answer to the problems identified above.
That said, the pitfalls of a small internal market should not be underestimated, not least because after the hoped for upturn in fortunes in the next year or two onwards there will inevitably be yet another downturn (following a period of boom), when the notional value of a practice under a valuation scheme and/or what retiring principals originally paid to acquire their interest in the business may exceed what prospective incomers are prepared to pay.
The cyclical nature of the world economy, or a downturn in a practice’s fortunes for other reasons, can lead to the breakdown of a valuation scheme and/or difficulty in recruiting new partners, as well as, in some cases, a great deal of heartache, if not acrimony. Increasingly, accountancy and other professional practices may need to consider innovative structures for delivering appropriate rewards to principals.
Peter Garry is a partner and head of the Partnerships and Professional Practices Group of South East solicitors’ practice Cripps Harries Hall LLP