When equity partners in a law or accountancy firm (or those with a lawyer or accountant spouse) divorce, careful consideration needs to be given to the partner’s financial position and the disclosure required to understand and corroborate it.
The starting point in financial negotiations is the production of the Form E. The Form E should include details of the partner’s capital and income resources, as set out below. While some of the relevant financial information will be attached to the Form E, additional detail will likely be requested through questionnaires and, if appropriate, expert evidence.
Whether advising the partner or their spouse, we will need a broad understanding of the type of work the law or accountancy firm does and the particular partner’s specialisms. We also need to understand the structure of the firm, for example whether they have salaried, fixed share equity partners and or full equity partners as this will have an impact on their capital interest in the firm and remuneration structure. The size of the firm will also be relevant. The value of a partner’s interest in a large limited-liability partnership is likely to be limited to the capital and net undrawn profits with no ability to sell or dispose of their interest other than when leaving the partnership. For a small partnership of just a few partners, consideration may be given in divorce proceedings to the value of the partner’s share of the partnership, the extent to which it is a matrimonial asset and how any value can be extracted.
In terms of financial disclosure in divorce proceedings, depending on the size of the firm, and whether a separate valuation of the partner’s share of the firm is required, the following should usually be requested:
- a partner’s profit distribution statements for the last three financial years;
- anticipated distribution or cashflow statements;
- the firm’s remuneration policy;
- the partnership deed;
- a letter from the firm’s finance partner or director summarising the remuneration position;
- partnership accounts;
- monthly management accounts,
- the partner’s tax return and the partnership’s tax return; and
- a partner’s capital, current and tax account statement.
In some firms the rest of the partners may not agree to all of the required documents being provided and some may need to be redacted. This is particularly relevant now in circumstances where there is a drive towards transparency in the family courts and members of the press may in due course be entitled to see documents filed within financial proceedings.
When joining a partnership, a partner is usually required to contribute capital to the business. For a junior or salaried partner, capital contributions may be minimal or not required at all. For a senior or equity partner, however, the capital contribution is significant.
The capital contribution is usually serviced by the partner taking out a specific partnership loan with a bank experienced in providing these. When considering financial disclosure in divorce proceedings, therefore, confirmation will need to be given in respect of whether the capital contribution was met by a loan and will effectively cancel out the funds otherwise held on that particular partner’s capital account.
Some firms have revolving credit facilities. This is a loan taken out by the firm rather than an individual partner and it reduces the need for individual partners to contribute. Such a facility would be guaranteed by the partnership and each partner would be allocated a portion of the liability. Some partners may be asked to make extra capital contributions throughout their membership, usually via their income. Such extra capital contributions will be owed to the partner (and not cancelled out by a corresponding loan), usually on retirement. Details of this should be provided on the Form E or by way of replies to the questionnaire.
Depending on when and how any capital contributions were made, funds held by the firm on the partner’s behalf may (or may not) be an asset of the marriage which forms part of the pot for distribution. The fact that undrawn capital exists, however, does not in itself mean that the parties can benefit from it straight away. There may be restrictions on the partner accessing the capital which in turn impacts if, when and how it should be distributed between the parties.
Partnership income is not straightforward and the net monthly sums available cannot easily be identified on a payslip.
A partner’s remuneration will depend on their specific role within the firm. A salaried partner will likely just receive a monthly salary rather than separate distributions of profit. A fixed share equity partner may receive monthly drawings and a distribution relating to their fixed share of the profits at certain intervals. A full equity partner is entitled to a larger share of the profits.
For full equity law firm partners, their remuneration is usually linked to either a traditional lockstep method or a modified points based system. Put simply, the more points you have, the more profit you are entitled to.
Partners are likely to be attributed a certain position on a lockstep ladder and allocated a number of lockstep points depending on their position on that ladder. Commonly, the more senior a partner is or higher their financial performance, the higher they will be on the lockstep. So if certain financial targets are met (which vary from firm to firm), a partner may be awarded a higher position on the lockstep. Some firms have gateways on the ladder which, once you have passed them, you will not subsequently go back down, therefore preserving a minimum position on the lockstep.
Each lockstep point is worth a certain sum each year, which usually depends on a firm’s profit. A partner should each year be able to confirm their historic and estimate their anticipated income based on their lockstep points and the current value per point.
Some firms also have additional merit based points allowances, in which case details will also be needed of the criteria to be met in respect of those points and their value. In divorce proceedings, therefore, you need to understand the firm’s particular pay structure and consider arguments which should or could be raised about the partner’s performance and assertions which may need to be made about their potential move back down the lockstep and the impact this would have on their future income/share of profit.
In very small firms, there may not be a lockstep or points based system and the partners may simply share in the profits made.
In terms of income, partners are entitled to both an amount of drawings each month (the level of which usually depends on the lockstep position) and separate profit distributions, which are the balance of the profit they are entitled to having taken drawings on a monthly basis. Drawings are payments in advance of an anticipated share of profit, whereas profit distributions are payments of the balance of profits not yet received. Given this, profit distributions usually relate to profit for the previous financial year (or older).
It is important to understand how this financial information is displayed on the Form E and also that there could be a difference between earnings (against which income tax and NI is calculated) and amounts actually paid/received in a financial year. For high earning law or accountancy firm partners, this can become particularly important as amounts received after separation may be subject to arguments about post separation accrual. It is also relevant to arguments about meeting income needs and liquidity where the financially weaker spouse is seeking maintenance.
Most law and accountancy firms estimate the amount of tax that a partner is going to have to pay on their profit entitlement and reserve funds in a tax account to pay tax on a partner’s behalf when due. Partners complete a tax return which will set out the income tax and national insurance due. Questions may need to be asked in respect of the tax reserve to ensure nothing is owed to or by the partner which was not taken into account at the time of disclosure and settlement. If funds are subsequently paid out (because too much was reserved for tax) or owed (because not enough was taken), this could turn out later to be unfair on one of the parties when it may be too late to do anything about it.
For smaller firms, it may be necessary to value the partnership as part of the divorce proceedings and expert evidence may therefore be required.
As with most business valuations, the expert will likely be asked to consider the value of the partnership, liquidity, the extent to which capital can be withdrawn in a given period, likely future income and the tax consequences of any withdrawals or distributions.
The expert will need to understand the nature of the firm, the number of employees and the pattern of work undertaken. It is also likely that they will want to speak with the firm’s accountants. Disclosure similar to the above will be provided but the accountants will have in depth knowledge of the firm and can explain anomalies in the accounts, discuss bad debts and detail anything which may not yet have been accounted for.
The valuer will be looking at the firm’s assets, historic fee income, monthly drawings, retained profit and whether all profit is usually withdrawn (which may be more common in smaller partnerships). Valuations for small law or accountancy firms are often undertaken on a net assets basis and with a consideration of whether goodwill should be separately valued.
In valuing goodwill, for small professional practices, a multiple of annual fees is usually used. The multiple itself will vary depending on the work carried out. We have seen that for firms with a recurring business model, such as auditing or repeat transactional work, a higher multiple is used than, for example, law firms which rely on litigation or other non-repeat work. Once the multiple has been selected, this is applied to the estimated future fees. In assessing likely future fees, the expert will consider whether to base this on historic performance or the firm’s most recent data. Considerations such as these have been particularly important where firms have been impacted by unusual conditions in the market, such as those brought about by Covid-19.
Finally, the expert will provide details of the income tax associated with the partner’s drawings (where this is not already known) and the CGT which would be incurred on any disposal of the partner’s share in the firm (subject also to any tax reliefs).
As with all financial resources on divorce, it is important that full disclosure is given so that the spouse’s financial position is clearly understood and consideration can then be given as to whether particular arguments about affordability, liquidity or non-matrimonial assets need to be run.
Connie Atkinson partner at Kingsley Napley.