Accounting

The ESOP alternative for CPA and accounting firms

Published

19 hours ago

December 17, 2024

Private equity’s run through the ranks of the accounting professions showed no signs of slowing in 2024. But recently, employee stock ownership plans have emerged as an alternative succession strategy for middle-market firms. Long-viewed as a tax-advantaged transition tool for accountants’ business clients, CPAs are now embracing ESOPs for their own firms.

Why? Because leveraged ESOPs circumvent deferred compensation dilemmas. At most firms, new partners must pull in revenue and generate profits to gradually pay departing partners. Paradoxically, departing partners are generally among a firm’s biggest producers. As a result, a single ownership transfer period can last as long as 10 years and is often completed below fair market value.

ESOPs enable new accountants to earn equity without having to fund a deferred compensation arrangement and without having to pay out of pocket to buy-in. Instead, an employee ownership transaction can provide for a seamless, rolling transition of ownership. Partial ESOP transactions are common, enabling firms to sell targeted blocks of retiring partner stock to an employee trust. But CPA firms can only unlock the utility of an ESOP when they fully tap into the relative flexibility of these strategies.

Creating supplemental incentive opportunities

Anyone who has advised an employee-owned client knows that ESOPs are ERISA-based, non-discriminatory benefit plans. All eligible employees receive stock based on the same egalitarian formula. That makes sense for a typical business, where tangible assets are created and monetized at an organizational level. But an accounting firm’s value creation rests largely on the shoulders of its tenured partners. A standard employee ownership structure may not offer enough upside to entice or retain high-performing talent.

Instead, CPA ESOPs are generally formed in tandem with nonqualified plans for firm leadership and top producers. These complementary structures are commonly used to create meaningful, discretionary phantom and synthetic equity opportunities.

Add-on benefits still need to be ERISA-compliant and negotiated as part of an ESOP formation. Nonetheless, supplemental plans are common fixtures at employee-owned professional service firms. These two-tiered strategies deliver short-term incentives to a firm’s established value creators, and long-term equity opportunities for all employees and future hires.

Normalizing EBITDA

Many broadly held accounting firms zero-out their net income in any given year. Meanwhile, ESOP valuations are often rooted in adjusted EBITDA multiples. To bridge this gap, firms often perform compensation scrapes, a common staple of private equity deal transactions. The resulting retained earnings will drive pre- and post-sale enterprise values.

Scrape calculations generally factor in a partner’s overall performance, productivity and tenure. A thoughtfully constructed scrape offers valuable trade-offs for impacted team members. Senior partners may take outsized reductions in their income to generate that excess retained earnings, with the expectation that they are near-term ESOP buyout targets. Junior partners can expect additional warrant or phantom stock grants that offer greater mid-to-long-term economic upside.

In addition to formalizing a firm’s valuation, EBITDA normalization and the resulting earnings retention creates a durable funding source for firm modernization and expansion. These investments are critical to continued competitiveness in an ever-consolidating industry.

In a properly structured ESOP, these earnings are also tax-advantaged. Employee-owned firms can receive corporate income tax deductions equivalent to the value of stock sold to an employee trust. In other words, a $50 million ESOP sale should yield a firm $50 million in deductions. Furthermore, a 100% employee-owned accounting practice can effectively operate income tax-free in perpetuity.

Understanding the big picture

So, let’s study these lessons in a practical context. Consider a 300-member, $50 million revenue accounting firm with a broadly held ownership group. Thirty percent of the partner base are senior members of the firm, eyeing retirement within five years. An ESOP strategy is developed to acquire equity from these senior partners at a fair market valuation.

First, a firm-wide compensation scrape (weighted toward senior partners) is performed and yields $10 million in EBITDA. Based on prevailing industry multiples and adjustments, the firm’s assumed valuation is set at $100 million. So, there’s an expectation of a negotiated $30 million ESOP sale price for 30% of the firm.

Next, commercial financing is secured so that senior partners receive up-front cash for the equity they’ve sold. These partners will have the opportunity to defer capital gains on their sale proceeds, thanks to an ESOP-exclusive tax benefit — the 1042 rollover. Over time, the firm will pay down the bank loan on the employee trust’s behalf, using pre-tax dollars.

Steps are also taken to make younger partners whole post-scrape. A stock appreciation rights plan is developed to deliver formal equity-sharing opportunities to established team members with longer time horizons. They’ll also have opportunities to sell their retained equity to the firm’s employee trust in the future, potentially with rights to exchange some of their shares for warrants. New partners will receive standard ESOP allocations and consideration to take part in the firm’s supplemental incentive program (at leadership’s discretion).

Either through retained equity or ESOP shares, the firm’s next generation of leaders will have concrete opportunities to monetize their stake in a more efficient, employee-owned firm — one that is retaining earnings for internal investment or potential acquisitions and realizing enhanced cash flow, fueled by the ESOP’s tax incentives.

From initial conception to final negotiations with an independent trustee, the transaction takes roughly six months to finalize. An experienced ESOP investment banking advisor and knowledgeable ERISA counsel help keep everything on track. In the end, retiring partners gain liquidity while remaining team members earn broad-based equity upside and additional incentives in a firm that’s primed for greater competitiveness — one in which all staff are rowing in the same direction to grow the practice over time.

What makes a good CPA ESOP candidate?

ESOP strategies are generally geared for top 500 accounting firms that aspire to sustainable, long-term growth. There must be an appetite for broad-based ownership and a willingness to build internal capacity. To build an employee stock ownership plan is to bet on yourself.

It’s not the right shareholder liquidity solution for every firm. But for forward-looking firms with leadership teams that seek market leadership for the foreseeable future, employee ownership represents a powerful tool. ESOPs take the industry’s greatest challenge — attracting, retaining and rewarding talent — head on, while aligning all staff behind a common goal at independent, CPA-led firms.

Accounting

In the blogs: On the horizon

Published

6 hours ago

December 17, 2024

Business Finance News

Crypto’s future; sobering CTC; inside and outside; and other highlights from our favorite tax bloggers.

On the horizon

Withum (https://www.withum.com/resources/): President-elect Trump has proposed several projects to boost the crypto sector, including dispensing capital gains tax for Bitcoin transactions and building a centralized Bitcoin holding account (a strategy reminiscent of America’s domination during the dot-com years). More clearly governed and with the support of the government, the crypto market could significantly increase in 2025.
Tax Vox (https://www.taxpolicycenter.org/taxvox): In 2025, the Tax Policy Center estimates that 17 million children younger than 17 will receive less than the full value of the Child Tax Credit because their parents earn too little. Most of these children also live in families that earn at least $2,500, the required minimum for any CTC beyond taxes owed. Congress has options when it debates the future of the CTC.
Institute on Taxation and Economic Policy (https://itep.org/category/blog/): As Congress negotiates federal funding during the lame-duck session, lawmakers would be wise to remember that stripping funds from the IRS costs more than it saves.
Dean Dorton (https://deandorton.com/insights/): Next year could be a big one for the M&A market. A look at key metrics good and bad, from lower borrowing costs and thawing credit to valuation gaps and regulatory scrutiny.
Avalara (https://www.avalara.com/blog/en/north-america.html): Canada gets ready to “join the sales tax holiday fun.”
Sikich (https://www.sikich.com/insights/): Sikich has entered into an agreement to acquire the federal contracts of Cherry Bekaert Advisory LLC supporting the U.S. Patent and Trademark Office.
HBK (https://hbkcpa.com/insights/): Reclassifying cannabis to Schedule III could expand access to banking, insurance, and other services for cannabis businesses. It may also ease the financial burden of Sec. 280E, which prohibits cannabis companies from taking standard business deductions due to marijuana’s current Schedule I status.
U of I Tax School (https://taxschool.illinois.edu/blog/): Interesting note on the beneficial ownership information reporting suspension: It invalidated much coursework and time in many tax schools this fall.

Good moves

Taxing Subjects (https://www.drakesoftware.com/blog): Preparing for the real season coming in the spring, from more IRS notices to high-net-worth clients to using artificial intelligence responsibly in your practice.
Canopy (https://www.getcanopy.com/blog): The importance of accountant-client privilege, the challenges in this age of technology and complex regulations, and how an accounting-based CRM platform is fundamental.
Turbotax (https://blog.turbotax.intuit.com): The “Moves That Matter” series kicks off with Drew, a lover of the outdoors from Montana. Interesting model in how to write a customer profile.
MBK (https://www.mbkcpa.com/insights): Estate planning is in many ways a big contingency plan. What about contingency plans for the beneficiaries?
Gordon Law (https://gordonlawltd.com/blog/): ‘Tis the season to tell them to stop sputtering: Why are bonuses taxed so heavily?

Virtual realities

Virginia – U.S. Tax Talk (https://us-tax.org/about-this-us-tax-blog/): How the “Bitcoin Jesus” now finds himself in a legal maelstrom after being arrested in Spain on U.S. charges of mail fraud, tax evasion and filing false returns.
Don’t Mess with Taxes (http://dontmesswithtaxes.typepad.com/): As internet betting continues to explode, a look at suggested tax rates of 15% to 25% of gross gaming revenue for new states where those feeling lucky can put their money down with a click.
TaxConnex (https://www.taxconnex.com/blog-): Holiday shopping season offers probably the year’s golden chance for your online biz clients, not only through sales on their own sites but also through household-name marketplace facilitators like Amazon. The glistening-once-again season also offers a big danger for your clients to ignite economic sales tax nexus.

Lowering the barter

Tax Foundation (https://taxfoundation.org/blog): The combined effect of net smuggling of cigarettes into U.S. states was a loss of more than $4.7 billion in forgone excise tax revenue in 2022. The annual effect of cigarette smuggling is significant, but the cumulative impact of annual smuggling from 2007 to 2022 demonstrates the severity of the issue when left to fester.
Mauled Again (http://mauledagain.blogspot.com/): “Analyzing the Federal Income Tax Consequences of a Crappy Barter Proposal.” Heavy on the “crappy.”
John R. Dundon II EA (http://johnrdundon.com/blog/): What to remind clients in biz partnerships about the difference between inside and outside basis.
Boyum & Barenscheer (https://www.myboyum.com/blog/): What to remind biz-owner clients about the good and bad of retained earnings.

Accounting

KPMG grows global revenue to $38.4 billion

Published

11 hours ago

December 17, 2024

Business Finance News

KPMG International reported annual aggregated revenues of its member firms globally grew 5.1% to $38.4 billion for the fiscal year ending Sept. 30, 2024.

The 5.1% increase over fiscal year 2023 was in local currency, and measured 5.4% in U.S. dollars.

The Big Four firm attributed this growth to its “collective strategy” and multibillion-dollar investments in aligned global priorities, while supporting clients through disruptions like artificial intelligence and shifting environmental, social and governance priorities.

The firm reported that tax and legal services grew by 10%, which the firm said was driven by client demand for its AI-enabled managed service and transformation capability, legal capability, and helping clients navigate global tax reform. KPMG also grew audit 6% and advisory 2%.

Last year, KPMG announced a U.S. $4.2 billion investment plan over three years as part of its collective strategy to build trust and drive growth, with over U.S. $1.7 billion invested across the KPMG network in FY24, with a focus on technology and AI, talent and ESG.

The offices of KPMG LLP in the Canary Wharf business and shopping district in London

KPMG grew its headcount by 1% to 275,288, which included targeted hiring in areas like tax and technology.

In terms of KPMG’s regional growth, the Europe, Middle East and Africa region was up 8%, the Americas up 4%, and Asia Pacific up 1%.

The firm also noted it has continued to invest in ESG services due to client demand, and previously addressed its commitment to becoming more responsible within its own business in the firm’s “Our Impact Plan” report.

Accounting

FASB proposes ASU on environmental credits

Published

13 hours ago

December 17, 2024

Business Finance News

The Financial Accounting Standards Board today proposed an Accounting Standards Update related to environmental credits and environmental credits obligations.

The changes in the proposed ASU aims to improve the understandability of financial accounting and reporting information about environmental credits and environmental credit obligations, and improve the comparability of that information by reducing diversity in practice.

Patrick Dorsman/Financial Accounting Foundation

Stakeholders noted that entities are increasingly subject to emissions-related government mandates and regulatory compliance programs, which often results in obligations that are settled with environmental credits. In addition, some entities voluntarily purchase environmental credits from third parties. Stakeholders also noted that generally accepted accounting principles does not provide specific guidance on how to recognize and measure this activity, which results in diversity in practice.

The proposed ASU provides recognition, measurement, presentation and disclosure requirements for all entities that purchase or hold environmental credits or have a regulatory compliance obligation that may be settled with those credits.

However, as the FASB’s role is to establish and improve financial accounting and reporting standards, this proposal only addresses amounts reported in financial statements. Measuring or tracking an entity’s voluntary emissions initiatives or actual greenhouse gas emissions are not addressed by the FASB or these proposed amendments.

The FASB is accepting review and input until April 15, 2025. The proposed ASU and information on how to submit comments is available at www.fasb.org.