Partner Agreements: Rules on Goodwill-Based Provisions

Firms without goodwill-based provisions in their partnership agreements may still be required to pay goodwill value to a departed partner.

The 2011 Rosenberg Survey showed that 23% of all CPA firms had no provision in their partnership agreements for goodwill based retirement payments (also called deferred comp payments) to partners departing due to death, disability, retirement, or withdrawal. 

If these firms think that being silent on the subject of payments to departing partners for the “goodwill value” or the “going concern value” of their partnership interests means they do not have to make these payments, they should think twice.  To the extent that the partnership agreement does not address the subject of payment to departing partners, the applicable state partnership law will govern.  Most state partnership laws provide that a departing partner is entitled to be paid his/her pro-rata share of the greater of the liquidation value of the firm’s assets or the firm’s going concern value unless the firm’s partnership agreement provides otherwise.   

Russell Shapiro is a partner with the Chicago law firm of Levenfeld Pearlstein and has worked with numerous CPA firms on firm governance issues and partnership agreement disputes.  Shapiro shared this with us:  “In a situation in which a firm’s partnership agreement is silent on paying goodwill-based retirement payments to a departed partner, the firm would often still be required to pay a separating partner for what, in essence, amounts to its goodwill value.  When a partner disassociates from a firm, the partner’s interest in the firm under most state partnership statutes must be purchased by the firm for a buyout price based on the greater of (a) the liquidated value of the firm’s assets if they were sold, and (b) the value of the firm based on a sale of the entire business as a going concern.  Going concern value would generally include a factor for goodwill.”

Shapiro further states that “as every CPA firm partner knows, the true value of a firm consists of the net book value on the firm’s balance sheet plus a factor for goodwill, the latter of which is almost always much higher than the former, especially when restrictive covenants are in place.”  This value is reaffirmed every time a firm is sold or merges into another firm.  When it is stated that the value of the buyout shall be based on the sale of the firm as a going concern, this would generally be interpreted to mean that goodwill will be included in calculating the value of the firm.”

While there are no clear guidelines or rules that the courts will use to determine the actual value of goodwill, the above clearly shows that firms whose partner agreements are silent on goodwill are still at risk if one of their partners departs and sues for payment of his value in the firm.

A simple solution

Shapiro has simple advice for firms who don’t wish to pay goodwill to departed partners:  “These firms should amend their partnership agreements by adding specific language stating exactly what they will pay to departing partners.  This will greatly strengthen the firm’s position.”  Of course, as with most legal rules, the information above is general, and varies from state to state.  Similar rules normally apply to limited liability companies but not necessarily to corporations.