Primer on Partnership-Compensation Models

By Denise Dickins, Thomas G. Noland, and Kenneth M. Washer

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In the authors’ discussions with partners, the themes of fairness, retirement, and rewarding top performers continually emerged. While each firm and partner are different, the following basic tenets should be considered when adopting a partnership compensation model:

• The model must be perceived as fair by both junior and senior partners.
• The model must not bankrupt the firm upon the retirement of senior partners.
• The model must reward top performers.
• The model may have to be changed as the firm evolves.

Admission to the Partnership

After senior managers have demonstrated some success, they may be asked to join their firm’s partnership. What’s next? Should the partner contribute money to the capital account immediately, or over a period of years? Does the firm even require a capital contribution? Two methods for admission to the partnership are discussed below.

Immediate capital contribution. Arthur Andersen used this approach, where each partner purchased a fixed number of partnership units (which generally ranged from 150 to 300, depending upon the partner’s classification). The purchase price per unit was routinely increased. At the time Andersen ceased its public accounting operations, new partners were required to make an initial contribution of approximately $250,000; financing was arranged through the firm. Andersen then credited interest to each partner’s capital account based on the partner’s capital account balance and current interest rates. From an individual partner’s perspective, the weakness of this model became apparent when Andersen dissolved and the partners lost the money in their capital accounts. Many newly admitted partners owed large note balances while no longer having an income source. The strength of this model is its new infusion of cash as new partners are admitted and old partners retire and withdraw their capital from the firm.

A variation of this model requires new partners to contribute capital, but no interest accrues on the account. One regional firm requires new partners to contribute $50,000 upon admission to the partnership, an amount that has not changed for more than 20 years. The primary weakness of this model is that the individual partner’s $50,000 investment has a zero growth rate. Another weakness is that, because the required contribution is not adjusted for inflation, new partners contribute less than older partners did upon joining the partnership. A strength of this model is that a retiring or departing partner can withdraw her $50,000 from capital immediately, as it will be replaced with a new partner’s contribution with no effect on the current cash reserves.

Graduated capital contributions. This model requires no immediate capital contribution, instead requiring new partners to contribute a percentage of their pay over a period of time. For example, if a firm required a total capital contribution of $150,000, the amount may have to be paid over five years ($30,000 a year). One strength of this model is that it requires no immediate cash outlay for a new partner. Unlike the Andersen model, if the firm ceases to exist, newly admitted partners do not remain liable for a large note. From an organizational perspective, a weakness of this model is that partners may not see themselves at risk and may simply view their compensation as a net of the annual amount received.

Annual Compensation

More accounting firms are structuring compensation similar to a corporate model, with a guaranteed salary and a bonus based on performance. Other firms pay their partners compensation based upon the percentage of ownership. Others use a hybrid of these two methods, with annual pay, a bonus, and then the remaining profits split based upon ownership percentages. Some firms pay junior partners only a salary and have a fixed time period before they can join in profit-sharing. Some firms call certain professionals partners even if these individuals have no ownership percentage. Several managing partners stated that one of their biggest challenges is to ensure that both junior and senior partners perceive the compensation model as fair.

Corporate structure. This model pays partners a “guaranteed salary” and a bonus based on performance. Any profits remaining at the end of each year are paid out based on the partner’s ownership percentage in the firm. By paying out a guaranteed salary, the firm recognizes that each partner should be paid for the job they do every day, before dividing profits. Normally an executive committee or a managing partner establishes salary and bonus objectives at the beginning of the year, so that each partner knows what performance level has to be reached to maximize compensation. Additional ownership shares of the partnership may be assigned or sold to a partner based on factors such as the retirement of other partners, new business development, and leadership potential. Each partner may be required to keep a fixed dollar amount or a percentage of compensation in an individual capital account.

The basic strength of this model is that top performers can still be rewarded in down years. By establishing bonus objectives at the beginning of the year, one partner may have a big year while another earns only a base salary. A weakness of this model is that it may encourage reckless behaviors as individual partners attempt to maximize their personal income. For example, if other controls are not in place, a partner may take an overly risky client, or may compromise an accounting position in order to retain a client.

Partnership apprentice. This model admits a partner to the partnership, but makes them ineligible for profit-sharing for a fixed time. One firm fixes new partners’ salaries for the first three years (adjusted annually) and then begins profit-sharing in the fourth year. Each new partner is assigned or can purchase the same ownership percentage, which can be increased each year by factors such as revenue growth of the entire partnership, client volume managed by the partner, the partner’s billable hours, the partner’s administrative duties, and the write-off percentage. This model allows existing partners to see how new partners perform before they share in the profits. Animosity, however, may result as young partners work for three years without immediate rewards.

Traditional. Similar to standard partnership structures, this model provides no guaranteed salary to its partners. Instead, all partners share in the firm’s residual income based on their share of ownership. Partners receive distributions periodically throughout the year depending upon expected earnings, which are adjusted throughout the year. At the end of the year, distributions are “trued up” based on the firm’s actual performance. At Andersen, which used a version of this model, substantially all newly admitted partners received (purchased) the same number of partnership units. Every two years, each partner was eligible to purchase additional units, contingent upon performance. Performance evaluations considered technical skills, knowledge sharing and client development across the firm, retention and development of staff, and achievement of financial goals. As with the partnership apprentice model, if partnership ownership percentages are not reduced as partners approach retirement and their personal production decreases, dissatisfaction among younger partners is possible.

Retirement and Dismissal from the Partnership

Many firms have both a mandatory and a minimum retirement age. Most firms provide a retirement benefit, although the amount can vary dramatically. In some cases, partners that leave before the established minimum age face stiff penalties. One firm requires an individual to serve at least 10 years as a partner before being eligible for retirement. Another firm levies a 20% reduction in accumulated benefits if a partner does not give a two-year notice before leaving the firm. A minimum payout period allows the firm to have an orderly withdrawal of funds if several partners leave at the same time.

If a partner leaves on her own before the minimum retirement age, she may be entitled only to the money in her capital account, which is often paid out over a certain period of time. Some firms allow an individual partner’s capital to be repurchased at its fair value at the time of retirement or dismissal. Some firms, like Andersen, buy back the amount of each partner’s capital account, plus accrued interest. Effectively, contributions are treated more like loans than like capital.

If a partner is dismissed, in addition to the return of capital, he may be entitled to a severance package. One firm gave a lump-sum payment equal to the partner’s last full-year compensation as part of a severance agreement, contingent upon the dismissed partner’s not practicing public accounting within 100 miles for a three-year period. This partner was also entitled to accumulated retirement benefits based on the firm’s retirement formula.

Funded retirement. There are two versions of this model. In the first, the partner contributes a percentage of pay or a fixed dollar amount to his own retirement account on an after-tax basis. Contributions are set aside in each partner’s name, and earnings are periodically credited to individual accounts and included in taxable income. Upon retirement, withdrawals other than current interest are tax free. The strengths of this model are that the individual partner’s retirement benefit is generally a function of the individual partner’s performance during her tenure; the firm can maintain its capital in the event of several retirements at once; and existing or future partners do not have to fund current retirement benefits. A weakness of this model is that the tax rate attributable to the retirement benefits is generally higher than it would be if the partner were taxed at the time of receipt instead of at the time of contribution.

In a second version of funded retirement, the firm, rather than individual partners, contributes to partners’ retirement accounts. The firm’s contributions are usually calculated to be an amount necessary to provide a defined retirement benefit. Upon retirement, withdrawals are taxable to the partner. A strength of this version is that partners are “forced” to set aside money for retirement, in the form of receiving smaller distributions during their tenure. Because the income is deferred to retirement, the tax rate on benefits received should be lower. A weakness of this model is that retirement benefits are not necessarily a function of each individual partner’s performance, depending upon the methodology established to determine the amount of the retirement benefit.

Unfunded retirement. Retiring partners are often paid a percentage of their earnings at the time of their retirement over a period of 10 to 15 years. This retirement benefit is paid by the firm out of current earnings before distributions to current partners are paid. A weakness of this model is that active partners’ compensation could be severely impacted in a bad year because of the requirement to pay retired partners first. One firm had an unusual variation of this model. Upon retirement, partners were paid a percentage of their pay for the next 10 years. But instead of paying them based on their final year or an average of several years compensation, the firm based the benefits on their compensation from 10 years earlier. One weakness of this model is that it allows partners to coast into retirement, secure in what their retirement pay will be. A weakness from a strong performer’s perspective is that the individual is not rewarded for the last 10 years they work. The firm benefits from this model because it does not have to pay retired partners for inflation adjustment increases over the last 10 years.

One regional firm stated that adjustments needed to be made to their retirement model because of the expected retirement of several key members of the firm at the same time. The impact of funding several retired partners for 10 years from current profits might hurt the firm when potential new partners consider the 10-year impact on firm profits.

No Single Solution

There is no fixed model for partner compensation. Each firm must adopt a model that fits its needs while taking into consideration fairness among the partners, retirement needs, and rewarding top performers. A firm that follows these basic tenets will likely have partners that are satisfied with the firm’s compensation model.