February 21, 2006
Unfunded Liability Results in Law Firm Dissolutions
In a previous post I asked, “How old is your partner team?” An even more critical question is, “Does your partnership agreement or operating agreement create an unfunded liability?” If so, it could be a fatal flaw unless corrected.
Partner agreements can call for significant continuing compensation to retired partners. Given our tax laws, law firms pay out their profits on an “as they go” basis. There is no material retained earning—no significant ownership equity for the retiring partner. Law firm income isn’t distributed based on monetary investment. It is required to compensate active partners for their relative contribution to revenues and profits.
Agreements that provide for continuing origination credits, or other amounts, to be paid to an inactive partner place a burden on the next generation of partners. As baby boomers reach retirement age, the problem is worsening. The number of situations where the burden has broken the backs of remaining partners is increasing. Their response isn’t surprising—they simply dissolve the firm.
Retirement plans need to be funded by the individual or jointly by the firm and the individual during their productive years. Because profits have been paid out as earned, the retiring partners have no claim on future income once they are out of the picture. If your firm has this problem, it is in the interest of all parties to find a win/win solution that will preserve the firm and treat all the partners fairly.
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Filed under Partner Agreements by Tom Collins