General Solo & Small Firm Section May 1998 Newsletter Articles

What Does Specialization Mean to Us?
by John R. Branson

What If Something Happens to Me?
by William J. Sanders, CPA and David Jamison*

Specialization is a reality for members of the Tennessee Bar. How does specialization affect us, the members of the general, solo and small firm section? Is it good for our clients? Does it benefit the society our profession serves? Does it do what it is supposed to do?
Solo and small firm practitioners constitute over 60% of the practicing lawyers in this state and in the nation. We fancy ourselves to be the guardians of the traditions of a noble profession. But in addition to all of the other pressures we face, we now have to deal with specialization, which some say may be having serious negative consequences for us and for the public. It is difficult for many generalists to meet the requirements relating to percentage of practice devoted to a practice area and the number of matters handled in a specialty, although the lawyer may be very competent and very effective in the area. In the words of section member Al Johnson, of Spencer:

“A general practitioner is a very important source of quality legal services for the citizens of Tennessee. But, because the current system of certification requires that a significant portion of a lawyer’s work be in a particular field, the general practitioner is prohibited from obtaining certification. He or she may be a much better attorney in a certifiable field than those certified, but the general practitioner cannot qualify. To the average citizen, it looks as though the specialist is more qualified to handle their case, and they will drive right past the better lawyer’s office to hire a certified, but less qualified specialist. Often the certified specialist is in another city and county. Thus, the rural general practitioner who sacrifices income to serve a rural population is shunned when the ‘good’ cases come about.”

There appears to be growing concern among opinion leaders in the bar that the trend toward ever-narrower specialization is bad for lawyers, particularly solo and small firm lawyers, and ultimately, bad for clients. In the words of one writer:

“The conventional wisdom is all wet. Specialization is not the solution, it’s the problem. It breeds uniformity. It leads to boredom. It dulls the senses, deadens the lawyer’s creative edge and deprives the client of imaginative advice...
Ironically, as lawyers strive to become more efficient specialists, clients increasingly wish to deal with one ‘whole lawyer.’ Clients are poorly served when the attorney loses the ability to innovate and think creatively.” (D. Bodney, “Keeping the Flame Alive,” ABA Journal, September 1995, p. 108.)
Indeed, according to a recent survey, small-firm and solo practitioners are the most satisfied of lawyers with their work, while associates in big firms are the least. (L. Gatland, “Dangerous Dedication,” ABA Journal, December 1997, pp. 28-29.)
Thus, if generalists are the happiest lawyers and specialists the least, and happier lawyers are better for clients, then certification may have a negative impact upon lawyers, particularly us, and for the public. But it seems as though specialization is here to stay; are there ways to make it better?
Al Johnson suggests that generalists could be allowed to take the exams and at least hold themselves out as having passed the tests, or that some other mechanism be devised to allow a generalist to show that his or her capabilities in a given field are substantial. What about certification as a generalist, with proven competence in particular areas? Or should we do away with certification altogether, in the hope that it will slow the growth of specialization?
What do you think? Drop me a line at:
44 North Second Street, Suite 701
Memphis, Tennessee 38103
or a fax at:
(901) 523-8008
or an e-mail at:
BandBlaw@ix.netcom.com.
I’ll try to follow up in a later column.

Solo and small firm lawyers must deal with a problem faced by all owners of small businesses: What happens if I die or become disabled? There is always so much to do in a small law practice that the owner(s) often never get(s) around to deciding what surviving partners or family members will do with the business (it is, after all, in part a business) upon the lawyer’s death or disability. This article will attempt to address that. Please note that we have used the terms “partner” and “owner” interchangeably.
An interest in a law practice can be either a benefit - as it should be - or a financial and emotional burden. The outcome will depend on whether the owner cared enough to plan ahead for the disposition of the practice. Planning ahead starts with knowing the issues.
The following discussion outlines various issues that need a plan of business continuity. The material should help you assess your own plan and determine if it will accomplish your objectives.
For those of you who have no plan, the discussion will set out some of the considerations that should be addressed in developing one. Let’s begin by distinguishing between those practices that are owned by unrelated owners or partners and those that are intended to stay within a lawyer’s family.
Unrelated Owners
When dealing with unrelated owners, the focus of a business continuity plan should be on preserving the value of the business for the benefit of the owner’s family.
This usually requires a buy-sell agreement that creates a market for a closely held business interest upon the occurrence of certain triggering events. Here is a series of points that can help you review your buy-sell agreement if you have one, or help you create one if you don’t. In either case, the objective is a buy-sell agreement that will properly control the disposition of an interest in your practice.
Searching for Successors
According to a recent survey, 40% of the businesses that expect the leader to retire or semi-retire in five years have yet to pick a successor to the current leader. In cases where a successor has been selected, 89% are family members. The median age of the planned successor is 38. The range in age varies widely; one is 75 years old and the youngest is a mere 12 months old. (He or she has some big shoes to fill.)
Forty-two percent say it’s possible that co-leaders may be selected for the next generation of leadership.
The Buy-Sell Agreement
A. Events
Does the buy-sell agreement contain the necessary triggering events?
Triggering events determine when a business owner’s interest in the business will be sold. The one most often used is the death of a business owner. By providing a market for the business interest upon death of a business owner, a buy-sell agreement makes available liquidity to pay estate taxes and a means of support for the family, while insuring that ownership and management of the business will remain with the surviving owners. Other triggering events that could prove equally important are:
1. Disability.
A disability buyout is important, especially where the business owners are also employees of the business. The business may not be in a position to replace the services of the disabled owner/lawyer and also provide disability income to the lawyer and his family. Furthermore, continuity of management may be threatened if an interest in the practice falls under the control of a guardian or trustee who does not work well with the remaining owners.
The solution may be found in a buyout of the disabled owner’s interest after the expiration of a waiting period that is long enough to rule out the possibility of recovery. Disability buyout insurance should be used when possible with the balance of any unfunded obligation payable in installments over a sufficient period of time to avoid putting a financial strain on the business.
Another important point to remember: Where insurance is used to fund the obligation, care should be taken to match the definition of disability contained in the buy-sell agreement.
2. Restriction on transfers during the life of a business owner.
It is common for the buy-sell agreement to impose lifetime restrictions that prevent a partner from transferring his or her interest in the practice without first offering it to the other partners at a price contained in the agreement. This restriction, along with the obligation to purchase the business interest upon death, helps establish a value for estate tax purposes. It also ensures that the practice can not be sold out from under the control of the owners. An exception should be made in some cases for transfers to family members or to trusts for their benefit, provided that the transferred interest remains subject to the terms of the agreement. This enables the lawyer to implement a gifting program that will reduce the exposure of the firm to estate taxes.
3. Involuntary alienation.
A buyout should be triggered in the event an interest in the practice is involuntarily alienated because of a divorce or claims of creditors. This contingency should be specifically stated in the agreement because the normal restrictions applying to voluntary transfers during the owners’ lifetimes may not apply.
4. Termination of employment.
Where all the partners are employed in the firm, consideration should be given to providing for the buyout of an interest in the firm if an owner voluntarily terminates employment or is terminated for cause. This will eliminate the potential for conflict with a minority owner who is no longer an active participant in the management of the business.
5. Right to Sell or Buy.
There may be situations other than the ones mentioned above where it would be better for the firm as well as the owners, to have a market for a closely held interest. A put gives an owner the right to require that the entity or other owners purchase some or all of an interest in a firm at a price determined by the buy-sell agreement. A call is the reverse of a put in that it gives the firm the right to purchase the interest from the owner. This ability to create a market for a closely held interest can provide significant protection to an owner who, for example, owns a minority interest and who is not active in the business (such as a retired partner). The buyout can be conditioned upon the occurrence of an event such as a change in management or control of the business.
Fair Market Value
Does the value determined by the buy-sell agreement reflect the fair market value of the business interest?
The most important provision of a buy-sell agreement is the one that establishes the price to be paid for the business interest.
The principal objective should be to receive full fair market value when dealing with unrelated owners, as opposed to establishing the lowest acceptable value for estate tax purposes.
Many business owners do not perceive this to be a problem. Unfortunately, they forget that they may not be present when the price is determined. Will the heirs of the business partner be as effective in arriving at a fair price if they have little or no working knowledge of it? The following methods are commonly used in a buy-sell agreement to establish a purchase price:
1. Appraisers
Appraisers are named to establish the price. While one appraiser is sufficient, often a team of appraisers is used. For example, the agreement may stipulate that the buyer and seller each appoint an appraiser, and they choose another. A majority vote of these appraisers will then establish the value of the business interest.
2. Stated price
The agreement may contain an agreed price that must be periodically reviewed and updated. Unfortunately, the update is often ignored. Therefore, it is important to provide for a backup method of valuation. For example, if no review of the stated price has been conducted within a certain period, appraisers will be appointed by the interested parties to establish the price.
3. Formula
Formulas can be used that accurately reflect the fair market value of the business. The formula should reflect the business’ going concern value unless it can be shown that the business will be liquidated.
Income Taxes
Does the design of the buy-sell agreement take into consideration the impact of income taxes?
To answer this question, let’s look at the three basic types of buy-sell agreements:
A redemption agreement, under which the business entity purchases the business interest.
A cross-purchase agreement, under which the remaining owners purchase the business interest.
A hybrid agreement, which is a combination of a redemption and cross-purchase agreement. First, the business entity has an option to purchase. To the extent the entity fails to exercise this option, the option shifts to the remaining owners.
Basis step-up
Income tax considerations play a role in determining which of these types of agreements is used.
A step-up in basis in this context simply means an increase in the amount paid by the business owner for an interest in the business. This has the effect of reducing any capital gains in the event the business is subsequently sold. Accordingly, the inability to credit an owner’s basis with the amount paid by the business when redeeming stock of a deceased owner translates into additional capital gains.
If this is a concern, consideration should be given to using a cross-purchase agreement, in which the interest is purchased by the remaining owners and not by the business. This will produce the desired step-up in the income tax basis of the business interests of the remaining owners equal to the purchase price.
Corporate alternative minimum tax
A cross-purchase agreement will avoid subjecting life insurance to the corporate alternative minimum tax. This tax may be triggered when the death benefit is paid to a professional corporation in order to fund a redemption agreement. No such tax accrues when the life insurance proceeds are paid to the remaining shareholders to fund a cross-purchase agreement. It is important to note that this exposure to the corporate alternative minimum tax does not apply to a professional limited liability company because its income is passed through to its shareholders.
Adequate Funds
Is the buy-sell agreement adequately funded?
Most buy-sell agreements are funded with life insurance for a very sound reason: The alternative sources of funding are usually not as attractive. Life insurance provides the assurance that the heirs of the deceased owner will be paid and that they will not have to rely on the continued success of the practice to pay an outstanding balance on an installment note that could last for several years.
The unanticipated death of an owner can impose a financial strain on the business if the revenues of the business are relied on for the funding. Furthermore, a business may be prevented from meeting its obligation under a buy-sell agreement because outstanding loan agreements require that certain financial ratios be maintained. The violation of these ratios could cause the loans to be called, further compounding the financial pressure on the practice.
Reliance on the credit of the practice to fund the buyout may be difficult, especially if the need results from the loss of a key partner. The practice cannot jeopardize lines of credit needed to finance its ongoing operations.
Finally, the buy-sell agreement should provide for an installment purchase of an owner’s interest when insurance is not available. For example, a living buyout of an owner because of retirement or termination of employment should be purchased with installments paid over a period that will avoid placing a financial strain on the practice.
Family-owned Practices
When dealing with a family-owned practice, as compared to one with un-related owners, the focus shifts from one of maximizing the value of the business interest through the use of a buy-sell agreement to one of minimizing the cost of keeping the practice in the family.
The principal expense in this case is the gift and estate tax payable on transfers of interests in the business to family members who have been identified as successor owners. In many cases, the ongoing success of the practice will depend on whether this objective has been achieved. Failure to plan for this ownership transition will result in the practice having to assume an additional financial burden at a difficult time when it has just lost a key lawyer.
What objectives should be part of a lawyer’s estate plan when the practice will be retained in the family?
The plan should create a synergy among three competing objectives:
The need to pass control of the practice to those children who are lawyers and who are active in the business.
The need to provide for the financial well-being of the owner and his or her spouse, separate and apart from the practice.
The need to treat fairly the children who choose to be inactive in the practice.
Objectives
The answers to the following questions will help you determine if your plan achieves these objectives:
1. Will control of the practice pass from the owner to the relatives who are active in the practice? Or will it pass to a spouse who is not active in the practice? Or pass equally to the children regardless of whether they are active or inactive in the practice?
2. If the active children have not been identified, does the plan give all of the children who are qualified an opportunity to come into the practice?
3. Is a gifting program being implemented that will minimize the estate tax exposure on the transfer of the practice to the next generation?
4. Has a savings plan been instituted that is designed to create assets that can fund both retirement and survivor income needs separate and apart from the practice?
5. Will there be sufficient non-practice assets available to fund the inheritance of the children not active in the practice?
When should control of the practice pass to the children active in the practice?
In most cases, control should pass directly from the owner to the children active in the practice. This can be accomplished either through gifts during life, through bequests upon death, or by sale pursuant to a buy-sell agreement.
Whether the practice should be sold to these active children will depend on whether there are sufficient non-firm assets to accomplish the other two objectives: (1) provide for the financial well-being of the owner and spouse, and (2) treat the inactive children fairly.
Proper planning will fund the retirement needs of the owner and spouse through the use of qualified retirement plans and investments outside the business. Even non-qualified retirement plans should be considered because they obligate the practice to pay a deductible retirement benefit long after the owner is no longer active in the practice.


* Messers Sanders and Jamison are Registered Financial Representatives with Vandersteeg Financial Corporation in Memphis, Tennessee.