Season of Goodwill
14 November 2005
For years, the majority of UK law firms have not required incoming partners to pay for goodwill, but have skewed profit-sharing towards those who have been partners the longest. Now there are forces at play - age discrimination, the Clementi reforms and tax - which could signal the end of lockstep and the return of payments for goodwill in some firms.
The traditional lockstep model has been the cornerstone of partnership remuneration for many years. At its heart has been a progressive increase in an individual's share of profit dependent on the time served as an equity partner to a maximum level after a defined period.
Although widely adopted, lockstep has not been without its detractors. The key complaint is that lockstep does not adequately reflect current contribution to profit, whether by marketing success or fee income. It is typically the younger partner, who is at the bottom of the lockstep and who has had particular success in, say, fee income, that normally advances 'the merit argument'.
The stock answer is that the fee income derives from clients which are either existing longstanding clients of the firm or are attracted to the firm by its good name: in effect, that the younger partner is only able to achieve high fee income by exploiting the firm's goodwill, for which no payment has been made. The lockstep recognises this goodwill, derived from the labours of partners in earlier years, by giving a larger proportion of the profit to the more long-serving partners.
The merit argument has been answered by variations to the basic lockstep which introduce some merit-based element, often by way of a discretionary pool or separate merit elements, and/or by requiring performance to be assessed rigorously before a progressing partner can scale the profit-share ladder.
A new factor on the horizon next year is the age discrimination legislation. Many commentators suggest that lockstep is inherently age discriminatory. It is, of course, a basic feature of the lockstep system that the more long-serving partners have a greater share of profit and that they are typically older. This is likely to make those firms which are not prepared to take the risk of discrimination consider a prompt change to a purer merit-based system. (Other firms may take a calculated risk that no partner will object to a system that will ultimately benefit them.) Assuming all partners contribute equally, a merit system erodes from senior partners the benefit of a guaranteed greater profit share, which lockstep provides.
Those affected adversely by losing the benefits of lockstep may look to other methods of reflecting an interest in goodwill.
Most professional partnerships have not recognised any capital value for goodwill: partners typically join without paying for the right to share in profit (except often by contributing capital that is no more than a loan to the firm and is repaid at par upon leaving) and leave without receiving any capital gain. The reasons for this are perhaps lost in time, but will include:
- The difficulty in measurement.
- The fear of a capital loss.
- The creation of a barrier to entry into partnership.
- The historic goodwill argument is not as robust as might be thought.
A second pressure for solicitors to consider about the capital value of their firms is the Clementi reforms, which will grant external stakeholders the ability to raise capital and have an effective market in 'shares', both internal and possibly external.
Although requiring some careful drafting, there is nothing in the highly flexible nature of the limited-liability partnership (LLP), or even the Partnership Act 1890, that would prevent classes of membership being able to mirror the share structures that could be found in a limited company. Thus, capital interests could be created that might attract 'dividends' and/or have an interest in the capital assets (including goodwill) and hence a capital value. This would enable a partner to sell their 'shares' on retirement to realise a capital gain.
Such a market would not be a panacea and some of the traditional objections to goodwill payments would still have to be addressed. First, the timing of any decision to capitalise would have the potential to operate harshly for those who 'missed the cut' either in joining or leaving. (This harshness could be mitigated by recognising capital values in incremental stages rather than in one hit.) Second, the requirement for new partners to buy in to the firm creates a potential barrier to its sustainability and, additionally, once a firm is on 'the value elevator' it can be hard to get off without a crystallising capital event for all.
Any value recognised in goodwill would be balanced by 'share capital' or loan accounts. Creating and drawing down loan accounts may have tax advantages, because value could be extracted as a tax-efficient repayment of the loan. The cost to a partner of buying goodwill would not itself be tax-deductible, although interest on a loan to buy it would be deductible at an individual's highest tax rate, making it more tax-efficient than a domestic mortgage, for example. On the sale of goodwill, a vendor would be liable to Capital Gains Tax (CGT). However, the annual CGT exemption and business asset taper relief, if available, could result in an effective tax rate of less than 10 per cent.
However, it is imperative not to let the tax tail wag the commercial dog: for example, not only might any tax advantage be at the expense of harmony between generations of partners, but there could also be onerous tax compliance burdens (requiring partners to calculate capital gains/losses arising on every change in profit-sharing ratios, if the goodwill is carried at value in the firm's balance sheet). And, of course, future changes to tax legislation might render the current analysis redundant.
Nevertheless, favourable tax consequences, together with proposed regulatory changes in age discrimination and modernisation of the profession, may all be factors in favour of the capitalisation of goodwill. Although many lawyers will earn a regular and reliable income over their professional lives, many have gazed in wonder and some jealousy at the prospects of their clients realising a substantial capital gain. They need gaze no longer.
Peter Ashford is a partner at Cripps Harries Hall and Simon Bevan is a partner at BDO Stoy Hayward