Another Change

Last week BDO confirmed that it was going to convert from an entity organized as a limited liability partnership under state law to one organized as a corporation.

With that, BDO became the latest in a growing list of highly regarded accounting firms to announce that it was going to change, or was considering a change in, its legal structure.

Although few details have been released thus far regarding the reason for BDO’s conversion, or the mechanics by which it will be effectuated, some of the rationale behind its move may be deduced from the activities of other large accounting firms, the legislative status of non-CPA firm ownership in New York, and the reason for such conversions by businesses organized as partnerships in other industries.

Strange Times

In 2021, Eisner announced that TowerBrook Capital Partners, an investment management firm with a private equity fund, was making a “significant” investment in Eisner.

In 2022, Citrin announced that the New Mountain Capital investment management and private equity firm was making a “majority investment” in the accounting firm.

Attest vs Non-Attest Services

In each case, the accounting firm had to restructure because accounting firms that provide attest services – including audits, reviews, and compilations – must be at least majority-owned by CPAs,[i] whereas non-attest services – such as tax planning, compliance and controversy, internal controls, valuation, M&A services, and other management and business services – are not subject to such ownership restrictions.[ii]

Thus, the attest services remained with the original accounting firm with its existing ownership, while the non-attest services were shifted into a new entity in which the original partners and the investment firm acquired an ownership interest;[iii] basically, a partnership division for tax purposes.[iv]

Mergers

In each case, following the investment by the non-accounting partner – and probably facilitated by such investment – the “acquired” accounting firm has, in turn, completed the acquisition of several other accounting firms.[v]

Most recently, Citrin acquired the non-attest business of Berdon.

E&Y’s Division Deferred

While the separation of the attest and non-attest services of most accounting firms would probably require the introduction of a new investor that is willing to make a sizable capital contribution, the same does not appear to apply to the Big Four.

It looked like E&Y LLP had a major reorganization plan in the works, by which it would have separated its non-attest business – i.e., consulting and tax services – from its audit business; it is my understanding that the non-attest business would have been transferred into a new corporation, with the partners receiving shares of stock in an initial public offering.

Those plans were temporarily shelved in April.

BDO

Query whether BDO will separate its attest and non-attest functions before incorporating, leaving the former in partnership form.

New York

In addition to the “blockbuster” transactions described above,[vi] it appears that the trend toward consolidation among smaller and midsized firms continues unabated.[vii]

Probably in acknowledgement of the foregoing developments, last month the New York State Senate and Assembly passed a bill[viii] – supported by the State Society of CPAs – that would allow non-CPAs to be minority owners of CPA firms.[ix]

According to the Official Summary of the bill:

“This legislation is needed so that New York CPA firms can better serve New York clients. As global competition, the complexity of business structures and rapid technological breakthroughs continue to redefine commerce, accounting firms of all sizes use the services of non-CPAs to help them navigate the dynamic terrain of today’s business environment.

“These non-CPA professionals are critically important to the effectiveness of a CPA practice. In today’s world, firms want to provide the best quality audits and this very often requires the skills of non-CPAs, such as systems engineers and other IT professionals, valuation specialists, actuaries, industry experts and others. Clients have come to expect that these specialists will participate in the CPA firm’s work and the audit work product is better because of it.

“CPA firm work, however, remains just that, the work of a CPA firm. This legislation limits the percentage of allowed non-CPA firm owners, ensuring that non-licensees can only ever have a minority interest in the firm. Further, enacting this legislation will even the playing field so that New York CPA firms will be permitted to have the same options to diversify their firm resources as firms in neighboring states who come into New York to practice under mobility. In addition, smaller CPA firms will find it easier to have a succession plan as they transition to the next generation.

“Many clients now expect that a CPA firm will employ non-CPAs with significant expertise in specialized areas such as information technology. Therefore, CPA firms have a real need to attract and retain the ‘best and brightest’ in these areas and to incorporate these individuals into the firm’s culture. The vast majority of states and jurisdictions have recognized this need and have implemented one method of doing this which is to give an individual an ownership stake in the firm so that all of these individuals have a shared interest in the long-term viability of the firm. This bill will benefit firms, the profession and the state by attracting additional business and job opportunities.”

The bill awaits Governor Hochul’s signature, which seems a certainty.[x]

Taxation of Business – Why Convert?

Funny you should ask.

Partnership Taxation

As we know, a partnership is business entity that has at least two members, that is not organized as a corporation under state law, and that has not elected[xi] to be treated as a corporation for tax purposes.[xii]

A partnership is a passthrough entity for federal income tax purposes – the partnership as such is not subject to the tax.[xiii] What’s more, it is generally not required to withhold and remit income tax or employment taxes on behalf of its partners.

Instead, each member of the partnership reports their distributive share of the partnership’s items of income, gain, deduction, loss, and credit on the member’s own return for purposes of determining the member’s income tax liability.

Each partner must also determine whether they are individually required to pay quarterly estimated taxes.

An individual member’s share of their partnership’s business profit is treated as ordinary income and, thus, is subject to federal income tax in the hands of the member at a marginal rate of 37 percent.

Moreover, a member’s share of profit is included in their gross income without regard to whether the partnership has made a distribution to the member.[xiv] In other words, the partners are taxed on the retained earnings of the business.

In general, an individual member’s distributive share of a partnership’s ordinary business income is included in their net earnings from self-employment and, so, is subject to self-employment tax.[xv] In addition, guaranteed payments to a partner for services actually rendered to or on behalf of the partnership are also subject to the self-employment tax.[xvi]

Corporate and Shareholder Tax

Unlike a partnership, a regular C corporation is itself a taxpayer. Its taxable income is subject to a federal income tax of 21 percent.

In determining its taxable income, the corporation is allowed to claim a deduction – as an ordinary and necessary business expense[xvii] – for compensation paid to its shareholders for personal services actually rendered to or on behalf of the corporation, provided the amount paid is reasonable under the circumstances.[xviii]

Of course, a shareholder-employee will include the compensation in their gross income, where it will be subject to federal tax as ordinary income at a marginal rate of 37 percent. The corporation will withhold and remit income taxes in respect of this compensation.[xix]

In addition, the compensation paid to a shareholder-employee will be subject to employment taxes; the corporation-employer will withhold and remit the employee’s share of such taxes, while also paying its own share of such taxes.[xx]

The corporation’s shareholders, as such, are generally not subject to tax with respect to the corporation’s profits until such profits are distributed to the shareholders in respect of their shares as a dividend.[xxi]

The corporation is not allowed to deduct its dividend distributions for purposes of determining its taxable income. However, the shareholders must include the dividend in income, though it will generally be subject to a preferred federal tax rate of 20 percent.[xxii] The shareholder may also be subject to the 3.8 percent federal surtax on net investment income.[xxiii]

Because the corporate profit that is distributed as a dividend to its shareholders is subject to tax twice – once to the corporation and once to the shareholders – these taxpayers have sought ways of reducing the overall tax on such income, usually by finding ways of making deductible payments to the shareholders.

Where the shareholders provide personal services, for example, as in the case of a professional corporation in which capital is not a material income-producing factor, they may be tempted to remove all of the corporation’s earnings as compensation. They do so at their own peril.[xxiv]

State Income Tax

Many professional business, including accounting firms, often operate in several states and may be required to file income tax returns in such states.

If the business is organized as a partnership, its partners are generally deemed to be engaged in business in every state in which the partnership is so engaged. Consequently, every partner may be required to file an individual income tax return with these states and remit tax on the partner’s share of partnership income sourced to that state. In addition, some states require that a partnership withhold and pay tax on each nonresident partner’s share of partnership income that is taxable by the state.

Alternatively, if the business is organized as a C corporation, the corporation will be required to file returns and pay taxes to the states in which it operates, but its shareholders, as such, will not be required to do so.

However, if the shareholder is also employed by the corporation and renders services outside their home state, they may be required to report and pay tax on their wages allocable to such services in the other state as a nonresident.

How to Convert

Assuming a partnership has decided that it would be in the best interests of the business and of its members for the partnership to be treated as a corporation for tax purposes,[xxv] it must then determine how to effectuate its metamorphosis.

There are several means by which to implement a conversion, though not all of them may be available in any one instance.

Assets Over

The partnership may transfer all of its assets to a newly formed corporation in exchange for all the outstanding stock of the corporation and the assumption by the corporation of the partnership’s liabilities. The partnership then terminates by distributing all the stock of the corporation to its partners in proportion to their partnership interests.

Assets Up

The partnership may distribute all of its assets and liabilities to its partners in proportion to their partnership interests in a transaction that constitutes a termination of the partnership.[xxvi] The partners then transfer all the assets received from the partnership to a newly formed corporation in exchange for all the outstanding stock of the corporation and the assumption by the corporation of the partnership’s liabilities that were assumed by the partners.

Interests Over

The partners of a partnership transfer their partnership interests to a newly formed corporation in exchange for all the outstanding stock of the corporation. This exchange terminates the partnership and all of its assets and liabilities became assets and liabilities of the corporation.

Check-the-Box

Unlike the first three alternatives, the check-the-box election does not change the legal form of the business entity under state law. Provided the entity is eligible[xxvii] to make such an election – for example, its default tax treatment is as a partnership[xxviii] – it may elect to change its tax status to that of a corporation (or association).[xxix]

Statutory Conversion

Some states allow a partnership to convert to a corporation by filing a certificate of conversion and a certificate of incorporation with the state’s secretary of state.[xxx] This process changes the legal form of the business entity buy operation of law.

Merger

Finally, state law may permit a partnership – for example, one formed as a limited liability company under state law – to merge with and into a corporation with the corporation surviving. The partnership’s assets and liabilities are transferred to the corporation by operation of law.

Tax Treatment

The Code provides that no gain or loss will be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange, such person or persons are in control of the corporation.[xxxi]

Each of the conversion methods discussed herein gets us to the same result – the “incorporation” of the partnership. Moreover, each relies upon the above-described tax-deferral provision.

That said, the specific tax consequences of incorporating a partnership – including, for example, the gain recognized, the corporation’s basis for the assets, and the shareholders’ basis for their stock – may vary depending upon which method is used.[xxxii]

Note, however, that each of the check-the-box election,[xxxiii] the merger, and the statutory conversion method[xxxiv] is treated as an assets over transaction for tax purposes.

Observations

As I started my final year in law school, I remember hearing what first-year associates were being paid at the large Manhattan firms. I couldn’t believe it – the figures were higher than I had ever imagined.[xxxv]

Shortly thereafter, we learned that certain firms had decided to increase those salaries to compete with the investment banking firms that had started to poach talent. Other firms followed suit.

I thought to myself, how does one pay for this? Will partners bear the cost or will clients?

The billable hours[xxxvi] that were extracted from us were also like nothing we had ever imagined,[xxxvii] but we were being paid well and we had student loans to service.

Much has changed since then.

For one thing, technology has changed the environment in which we practice. FedEx gave way to faxes, which gave way to emails, which changed client expectations, . . . , you know how the rest of it goes.

Now firms are talking about incorporating artificial intelligence into their practice,[xxxviii] and using it as a platform to expand their range of services.

Following the experiences gained during the pandemic, many attorneys are now working remotely and firms are concerned about attracting and retaining talent by offering quality-of-life inducements in addition to sizable salaries.

Will most firms be able to successfully reconcile these and other demands?

It appears, at least in the accounting world – and probably in the law business as well – that many have concluded that a larger firm will be better positioned to overcome these and other challenges.

The quickest way to adding expertise and achieving growth is through consolidation.

And the easiest, and least painful, way to raise the funds required to pay for such consolidation, to pay for talented employees, and to pay for the ever-changing technology that will be a necessary part of servicing clients effectively and efficiently, is to accept investments from non-accountants.

Query whether the partners in accounting firms expect that their now larger, enhanced firm may be sold to a still bigger player in the field[xxxix] – similar to the private equity strategy of rolling up smaller firms, building a cohesive and stronger whole, then selling the business.[xl]

Keep your fingers crossed as we see where this goes.

[i] EisnerAmper LLP and Citrin Cooperman & Company LLP.

[ii] Eisner Advisory Group LLC and Citrin Cooperman Advisors LLC.

[iii] Those familiar with the MSO structure in the medical arena will recognize the similarities, especially the separation of the clinical and non-clinical assets.

[iv] Reg. Sec. 1.708-1(d).

[v] I imagine the investment, as well as future infusions of capital, will also be applied toward updating and acquiring technology, including AI, and competing for talent. especially in the New York market.

[vi] I’m a tax guy. This stuff is both exciting and troubling. Many colleagues have shared they are glad to be retiring soon.

[vii] Probably too many reasons to set forth here. Size and access to expertise across many fields is one. The expense of keeping up with technological changes is certainly another.

[viii] S 2473.

[ix] For example, the bill would amend the business corporation law to authorize non-CPA ownership of a firm provided: Licensed CPAs must hold a simple majority of the ownership; a licensed CPA or CPA with practice privileges must be responsible for registration of the firm; the partner/owner in charge of attest services must be a licensed CPA; all non-CPA owners must be actively engaged in working for the firm or an affiliated entity; and passive ownership is not permitted.

[x] I am not thrilled by the prospect.

[xi] IRS Form 8832, Entity Classification Election.

[xii] Reg. Sec. 301.7701-2 and 301.7701-3.

[xiii] IRC Sec. 701.

[xiv] Reg. Sec. 1.702-1(a).

[xv] Under IRC Sec. 1402(a).

IRC Sec. 1401(a) and 1401(b) impose, respectively, for each taxable year, Old-Age, Survivors, and Disability Insurance tax and Hospital Insurance tax on the self- employment income of every individual. IRC Sec. 1402(b) generally provides that the term “self-employment income” means the net earnings from self-employment derived by an individual during any taxable year.

IRC Sec.1402(a) generally defines the term “net earnings from self-employment” as the gross income derived by an individual from any trade or business carried on by such individual, less certain deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in IRC Sec. 702(a)(8) from any trade or business carried on by a partnership of which he is a member, with certain enumerated exclusions. Generally, a partnership’s ordinary business income from operations is described in IRC Sec. 702(a)(8). A partner’s distributive share of a partnership’s ordinary business income from operations is generally subject to self-employment taxes unless an exception applies.

[xvi] IRC Sec. 707(c); Reg. Sec. 1.1402(a)-1(b).

[xvii] IRC Sec. 162.

[xviii] Reg. Sec. 1.162-7.

[xix] Thereby reducing or even eliminating the need for the shareholder to make quarterly estimated tax payments.

[xx] Basically, they split the cost of the 12.4% Social Security tax and the 2.9% Medicare tax. A partner bears the entire cost.

[xxi] IRC Sec. 301.

Some corporations may be tempted to forego the payment of a dividend. When a corporation retains earnings beyond the reasonable needs of its business, it may be subject to a 20% accumulated earnings tax that seeks to mimic the tax that would have been imposed on shareholders had the corporation made a dividend distribution.

[xxii] IRC Sec. 1(h).

[xxiii] IRC Sec. 1411.

[xxiv] Consider the independent investor test, for example, which has been applied in such circumstances by the Tax Court to deny a deduction to a corporation that uses shareholder-employee compensation to zero out its income.

Then there is the fact that non-owner employees may constitute profit centers.

[xxv] For purposes of this post, we are not considering the non-tax factors that may favor one form of business entity under state law over another.

[xxvi] IRC Sec. 708.

[xxvii] It is not treated as a “per se corporation” under Reg. Sec. 301.7701-2.

[xxviii] It is an eligible entity with at least two members.

[xxix] Reg. Sec. 301.7701-3. Form 8832 is filed for this purpose.

[xxx] DE for example; not NY. Oh well.

[xxxi] IRC Sec. 351.

[xxxii] Rev. Rul. 84-111.

The check-the-box election and the merger are both treated as “assets over” transactions for tax purposes.

[xxxiii] Reg. Sec. 301.7701-3(g).

[xxxiv] Rev. Rul. 2004-59.

[xxxv] Maybe $35,000 to $45,000 per year.

[xxxvi] I’m sure there were also rate increases.

[xxxvii] In too many instances, so was the abuse. The things that were said to us would have landed on the front pages of today’s overly sensitive press.

[xxxviii] Don’t get me started. Two quotes from Jeff Goldblum’s character, Dr. Ian Malcolm, in the Jurassic Park movies: “…your scientists were so preoccupied with whether or not they could that they didn’t stop to think if they should,” and “In the last century, we amassed landmark technological power, and we’ve consistently proven ourselves incapable of handling that power.”

[xxxix] What does that mean for retirement?

[xl] To quote The Highlander movie, “There can be only one.” I hope not.