Are Partner Retirement or Withdrawal Provisions in Governing Documents Subject to Section 409A of the Internal Revenue Code?
Accounting firm M&A deals often involve complex tax issues, and it’s important to understand their implications before undergoing negotiations and diligence so that you aren’t caught off-guard or have unwanted consequences. If you have any questions on this article, please do not hesitate to reach out to the author or Russell Shapiro, who leads LP’s Accounting Firm Practice.
As part of our ongoing series on tax issues for accounting firms, this article provides information on retirement or deferred compensation arrangements, the related rules of Section 409A of the Internal Revenue Code, and how these issues may impact M&A deal structures and negotiations.
With private equity entering the scene, M&A opportunities for accounting firms abound. The flurry of M&A activity in the industry has highlighted the importance of assessing retirement and deferred compensation arrangements in accounting firms.
It’s not uncommon for partners of an accounting firm to have retirement or withdrawal payments or deferred compensation payment rights that extend for years after the partner leaves the firm. These payments redeem the partner’s ownership in the firm and are paid by the revenue of the partnership in a stream of payments over years. A common example is a 10-year payment stream based on the 5-year average compensation the partner received prior to retirement. Often these promises are made in the governance document of the firm itself.
If a partner has a retirement, withdrawal, or deferred compensation payment right on buyout and the payment could be treated as a compensation deduction from the income of the firm, then we need to consider Section 409A of the Internal Revenue Code (“Section 409A”). For purposes of this article, these retirement, withdrawal, or deferred compensation payment rights are collectively referred to as a “retirement payment right” or “retirement payments.”
Broadly, if the firm is a partnership or a limited liability company taxed as a partnership, then Section 409A may not apply to the retirement payment right or its application may be delayed.
But note, if the firm is a corporation, including an “S” corporation, then Section 409A’s normal rules apply, including the possible assessment of taxes and penalties described below. This article doesn’t apply to corporations.
The Dreaded Section 409A
Before we delve into whether and when Section 409A may apply to a retirement payment, let’s explain what Section 409A is and why we care if it applies.
Section 409A governs “deferrals of compensation”: what they are; how they can be made; when and how they can be paid; how changes to payment are possible, if at all; and consequences of violation. Section 409A is rigid and unforgiving with broad application. A “deferral of compensation” governed by Section 409A generally includes any payment amount for services earned by a person in one tax year that may be payable in a later tax year. Given the sweeping definition of deferrals of compensation, many equity buyout provisions providing for retirement payments will be subject to Section 409A.
Many exceptions to this general rule exist that are so complicated they make Alice wandering in Wonderland jealous. We will talk about one later on, but for now, why do we care about Section 409A? Because the consequences of non-compliance are stiff.
Non-compliance with Section 409A’s requirements accelerates income taxes due on deferred amounts (whether payment is made or not – i.e., the phantom income problem), triggers a 20% excise tax layered on top of income taxes, and assesses an interest penalty tax at 1% above the IRS’s underpayment penalty rate. These adverse tax consequences apply to the deferred compensation holder, not the employer. Now, that’s a tough day at the office!
Although partnerships and limited liability companies taxed as partnerships are subject to 409A, such entities have a special exemption from the strong arm of Section 409A for certain payments made to a withdrawing or retiring partner. In that case, retirement payments can be exempt from 409A if the payments satisfy both of these requirements:
- The payments are taxed under Section 736 of the Internal Revenue Code. Section 736 payments are those made to a retiring/withdrawing partner to redeem or extinguish an existing partnership interest as:
- a distributive share of the partnership income;
- guaranteed payments; or
- payments as consideration for their membership interest.
Note: Section 736 payments only apply to firms taxed as partnerships. For corporations, including “S” corporations, this Section 409A exemption does not apply, and the general rule of earning compensation in one tax year that could be payable in another tax year applies.
What type of Section 736 payment the retiring partner receives is important for tax characterization, but for Section 409A purposes, it’s enough to know the payment is a Section 736 payment.
- The payments do not qualify the partner for an exemption from the Self-Employment Contributions Act (“SECA”) under Section 1402(a)(10) of the Code. If the SECA exemption doesn’t apply, then Section 409A doesn’t apply, or put another way, if the partner is required to make SECA contributions with respect to the payments, the Section 409A exemption may be available. The SECA exemption applies only if all of the following conditions are met:
- the retirement payment amounts received by a partner are received pursuant to a written plan that provides for payments to the partner generally, or to a class of partners, on account of retirement;
- the partner didn’t provide services to the partnership in the year the retirement payments commenced;
- there is no obligation due from the other partners to the retiring partner other than the retirement payments or medical or death benefit obligations;
- the partner’s capital has been fully paid before the commencement of the retirement payments; and
- the retirement payments under the plan are payable on a periodic basis (at least annually) and continue until the partner’s death.
Maintaining the SECA exemption requires careful planning. And while it seems complicated, many service partnership firms design their retirement payment provisions to meet these requirements.
For purposes of the Section 409A exemption related to retirement payments, the relevant SECA determination date is the last day of the tax year preceding the tax year in which retirement payments begin.
Retirement Payment Delay of 409A
If the retirement payments are structured to be exempt from SECA, then Section 409A would apply, which means the retiring partner could be subject to the income tax acceleration and other penalties mentioned above upon a violation of Section 409A.
Generally, Section 409A applies immediately upon execution of the contract providing for deferred compensation. Fortunately, for SECA-exempt retirement payments, while not exempt from Section 409A, the application of Section 409A is delayed until the partner retires and payments commence.
A fundamental precept of Section 409A is that the timing and form of a deferred compensation payment cannot change once an individual has a legally binding right to deferred compensation, unless specifically allowed by the regulations. Because Section 409A’s application is delayed under the special delay rule to retirement payments exempt from SECA, the regulations allow partnership firms to change the time and form of the retirement payment up until the partner commences payments. This means retirement payments for partners that have not commenced payments are exempt from Section 409A until December 31 of the year in which the partner retires because partners don’t commence payments until the year following retirement – which is one of the requirements of the SECA exemption.
The special delay rule is valuable in the context of an acquisition for those partners that have not commenced retirement payments, more on this below.
What does this all mean for accounting firm partnerships going through an acquisition?
When an accounting firm is acquired, both the ongoing payments to already retired partner and future retirement payments to current partners must be considered.
For current partners with future retirement payments, Section 409A either doesn’t apply to the retirement payments or its application is delayed until the end of the year the transaction closes if the retirement payments are structured to be exempt from SECA. Because Section 409A does not apply at the time of the transaction, this means all current partner retirement payment obligations can be restructured to align with the business terms of the deal without hazarding the consequences of non-compliance with Section 409A. As a result, each partner can consent to restructuring the future retirement payment, and, while each partner must be treated fairly, they can be treated differently. Usually, that means current partners waive their right to future retirement payments from the selling firm as a result of the consideration received in the acquisition, which may be a new retirement benefit from the buyer or a payment of cash or equity.
For already retired partners who commenced retirement payments that are not exempt from SECA, Section 409A does not apply. These individuals have the same flexibility as current partners with future retirement payments because Section 409A does not apply to their retirement payments.
For already retired partners that commenced retirement payments exempt from SECA, Section 409A applies because retirement payments have already commenced and the special delay rule has lapsed. Because these payments are subject to Section 409A, they must be continued on their current terms, either by the seller or through assumption by the buyer. Alternatively, the payment terms can be amended to accelerate the retirement payments upon a change in control event, provided that all retired partners with retirement payments exempt from SECA are fully paid within 12 months. This is done through terminating their similarly situated deferred compensation arrangements at closing. As a result, each retired partner must be treated uniformly. Getting agreement from all retired partners is a challenge. But it’s an all-or-nothing approach, and to do otherwise would violate Section 409A. The specter of Section 409A non-compliance looms large in these acquisitions, so if unanimous agreement from the retired partners cannot be obtained, payments should continue on their current terms. This is possible if the selling firm continues to pay the retired partners retirement payments on the same schedule or if the buying firm assumes these retirement payments.
Our suggestion: Carefully analyze retirement payments for Section 409A issues before making changes to the payment obligation. The retirement payment issues discussed in this article equally apply regardless of whether the payment promise is in the firm’s governing documents or some other written agreement, including an acquisition or employment agreement.