Are Partner Retirement or Withdrawal Provisions in Governing Documents Subject to Section 409A of the Internal Revenue Code?

Accounting firm M&A transactions often involve complex tax issues. One issue that should be reviewed early is whether partner retirement, withdrawal, or deferred compensation payment rights are subject to Section 409A of the Internal Revenue Code. If you have any questions on this article, please do not hesitate to reach out to the Kevin Burch or Russell Shapiro, who leads LP’s Accounting Firm Practice.

Accounting firms frequently promise payments to retiring or withdrawing partners that continue for years after the partner leaves the firm. These payment rights often appear in a partnership agreement, operating agreement, or other governing document. They may be based on a partner’s historical compensation, ownership interest, or another formula agreed to by the firm. For example, a firm may promise a 10-year payment stream based on the partner’s average compensation for the five years before retirement.

These arrangements matter in a transaction because the parties may want to restructure, waive, accelerate, assume, or otherwise modify the payment obligation. Before doing so, the firm must determine whether Section 409A applies. If it does, the flexibility to change the timing or form of payment may be limited.

For purposes of this article, partner retirement, withdrawal, and deferred compensation payment rights are referred to collectively as “retirement payment rights” or “retirement payments.”

A Simple Framework

Determining whether a partner retirement payment is subject to Section 409A generally requires answering three questions:

Does the retirement payment qualify for the SECA retirement payment exemption under Section 1402(a)(10) of the Internal Revenue Code?

Is the firm taxed as a partnership or as a corporation?

Does the payment qualify as a payment to a retiring or withdrawing partner under Section 736 of the Internal Revenue Code?

Why Section 409A Matters

Section 409A governs many nonqualified deferred compensation arrangements. In general, a deferral of compensation exists when a service provider obtains a legally binding right during one taxable year to compensation that may be paid in a later taxable year. The Section 409A regulations provide that this determination generally is made when the legally binding right arises.

Compliance matters because the tax consequences of non-compliance can be severe. If a nonqualified deferred compensation arrangement fails to satisfy Section 409A, deferred amounts may be immediately included in income, even before payment. In addition, the affected service provider may owe an additional 20% federal tax and an interest charge calculated under Section 409A.

For corporations, including S corporations, the partnership-specific rules discussed below do not apply. If a corporate retirement or withdrawal payment right is compensation earned in one year and payable in another year, Section 409A must be analyzed under the ordinary rules. This article focuses on partnerships and LLCs taxed as partnerships.

When Partnership Retirement Payments May Be Exempt From Section 409A

Partnerships and LLCs taxed as partnerships receive special treatment for certain payments made to retiring or withdrawing partners. A retirement payment may be exempt from Section 409A if two requirements are satisfied.

First, the payment must be treated as a payment under Section 736 of the Internal Revenue Code. Section 736 applies to payments made in liquidation of the interest of a retiring partner or a deceased partner. Depending on the structure, those payments may be treated as a distributive share of partnership income, a guaranteed payment, or a payment in exchange for the partner’s interest in partnership property.

For Section 409A purposes, the key point is not the precise tax characterization of the Section 736 payment. The key point is whether the payment is a Section 736 payment made in connection with the liquidation or redemption of the partner’s partnership interest.

Second, the payment must not qualify for the SECA retirement payment exemption under Section 1402(a)(10). Stated differently, if the partner is required to pay self-employment tax on the payments, the Section 409A exemption may be available.

The SECA Exemption and the Section 409A Delay Rule

Many professional service firms design retirement payment provisions to satisfy the SECA retirement payment exemption. That exemption can apply to certain periodic retirement payments made by a partnership under a written plan to a retired partner on account of retirement.

The SECA exemption generally requires that the payments be made under a written plan that provides retirement payments to partners generally, or to a class of partners; that the payments be made on a periodic basis at least annually; that the payments continue at least until the partner’s death; that the retired partner not provide services to the partnership in the year, particularly the year retirement payments commence; that no other obligations be owed by the partnership or other partners other than specified retirement, medical, or death benefits; and that the partner’s capital be fully paid before retirement payments begin. The SECA exemption is performed annually, and all requirements must be fulfilled for the full calendar year.

If the retirement payments qualify for the SECA exemption, they are not fully exempt from Section 409A. Instead, the Section 409A regulations provide a special delay rule. Under that rule, Section 409A generally does not apply until the partner retires and payments commence.

This delay rule is important because it may allow a partnership to modify the time and form of future retirement payments before the partner commences payments. In a transaction, that flexibility can be valuable. Current partners with future retirement payment rights often can agree to restructure or waive those rights as part of the deal, provided the restructuring occurs before Section 409A begins to apply.

Why This Matters in an Acquisition

When an accounting firm is acquired, the parties should identify and separately analyze both future retirement payment obligations owed to current partners and ongoing payment obligations owed to already retired partners. The Section 409A result may differ depending on whether payments have commenced and whether the payments are SECA-exempt.

Current Partners With Future Retirement Payment Rights

For current partners whose retirement payments have not commenced, Section 409A may not apply, or its application may be delayed. If the payment is a Section 736 payment and is not SECA-exempt, the payment generally may be exempt from Section 409A. If the payment is SECA-exempt, Section 409A generally may be delayed until the end of the year in which the partner retires and before payments commence.

As a result, current partners often can consent to a restructuring of future retirement payment rights in connection with a transaction. In many deals, current partners waive future retirement payments from the selling firm in exchange for transaction consideration, a new retirement benefit from the buyer, equity, cash, or some combination of those items.

Retired Partners Receiving Payments That Are Not SECA-Exempt

For already retired partners whose retirement payments have commenced and are not SECA-exempt, Section 409A generally does not apply if the payment qualifies for the partnership exemption. These retired partners may have similar flexibility to current partners, because the payments are not governed by Section 409A.

Retired Partners Receiving SECA-Exempt Payments

The analysis is different for already retired partners who are receiving SECA-exempt retirement payments. Once payments have commenced, the special Section 409A delay rule has lapsed. At that point, Section 409A applies to the payment arrangement.

If Section 409A applies, the payments generally should continue on their existing terms, either by the seller or through assumption by the buyer. Alternatively, the parties may be able to terminate and liquidate all similarly situated deferred compensation arrangements in connection with a qualifying change in control event, provided the requirements of the Section 409A regulations are satisfied. In that scenario, all similarly situated retired partners generally must be treated uniformly, and the arrangements must be terminated and paid within 12 months of terminating the deferred compensation arrangements.

This is often the most difficult category in a transaction. Either the retirement payment provisions allow the sponsor to termination without participant consent, or negotiations with each retired partner can gain the necessary consent.  If the required treatment of similarly situated retired partners cannot be obtained and the arrangement doesn’t allow the sponsor to terminate unilaterally, the safer approach is usually to continue the existing payment schedule rather than risk a Section 409A violation. That said, buyers often require all deferred compensation arrangements to be terminated and paid at closing, so there is a practical limitation to this option.

Practical Takeaways

• Do not assume that a payment right is outside Section 409A merely because it appears in a partnership agreement or operating agreement.
• Determine first whether the firm is taxed as a partnership or as a corporation. The special partnership analysis does not apply to corporations or S corporations.
• For partnerships and LLCs taxed as partnerships, determine whether the payment qualifies as a Section 736 payment.
• Determine whether the payment is SECA-exempt under Section 1402(a)(10). A non-SECA-exempt Section 736 payment may be exempt from Section 409A; a SECA-exempt payment may instead benefit from the special delay rule.
• In acquisitions, separately analyze current partners, retired partners receiving non-SECA-exempt payments, and retired partners receiving SECA-exempt payments.
• Analyze Section 409A before amending, accelerating, terminating, assuming, or restructuring retirement payment obligations.

Conclusion

The fact that a partner retirement or withdrawal payment right appears in a governing document does not, by itself, determine whether Section 409A applies. The analysis depends on the firm’s tax classification, whether the payment is treated as a Section 736 payment, and whether the retirement payment qualifies for the SECA retirement payment exemption.

For accounting firms and other professional service partnerships involved in M&A transactions, this analysis should be completed before the parties modify payment terms or finalize transaction consideration. Early review can preserve deal flexibility and reduce the risk of unintended Section 409A tax consequences.