Will Swearingen (Zweig Group), Kevin Johns (Clayton & McKervey), Alexis Martin (EPSA USA)
A tax advisor, CPA and transition expert discuss best practices when planning an ownership succession. These edited comments are from a panel discussion held in July 2023 as part of the Zweig Webinar Architecture & Engineering Series.
Ben Franklin’s adage that if you fail to plan, you plan to fail directly applies to ownership transitions. If you intend to sell your firm in the next decade, ask yourself
- How do I enhance the value of my firm before the transition?
- How do I build the next tier of leadership?
- What are my goals for the sale?
The latest Zweig survey shows that 73% of business owners prefer to transition internally, either to the next generation of partners or to an Employee Stock Ownership Plan. One can also merge with another firm or sell externally. You will have more options if you take simple steps to maximize value.
Prioritize the quality of financial statements.
Making sure that your financials are transparent and meet industry standards, that records are easily understood, and that performance is tracked over a decent period of time will enhance the firm’s appeal to buyers.
Other quantitative mechanisms that will drive value include the firm’s growth rate, profitability, consistency of performance, cash flow, industry presence, specialization, and ability to reduce debt.
Key Performance Indicators (KPIs) will provide the most useful data, specifically Net Service Revenue (NSR) per employee; Net Multiplier; employee utilization; Revenue Factor; overhead rate; pre-tax, pre-bonus profit; average collection period; backlog; proposals pending; and projects in the pipeline.
The efficiency metrics NSR and Net Multiplier are labor that is billed to projects. The Revenue Factor looks at total labor expenditure compared to NSR. It is a measure of the firm’s ability to generate revenue with the current labor pool.
When you are thinking about selling your firm, the last thing on your mind is business development. But do not let your foot off the gas. Every partner needs to be actively driving value well before transition talks begin.
Visible, Timely, Automated.
You may think that the books are balanced, but they probably do not meet GAAP criteria, that is, Generally Accepted Accounting Principles — the measurement that a buyer will use to evaluate the firm. Become fluent yourself or talk to us to mind the GAAP before considering succession.
Just as your car’s instrument panel is directly in front of you when driving, your firm’s KPIs should be immediately accessible. Automate the reporting and you will be able to make faster and wiser decisions on a daily basis, and enhance the firm’s value when it is time to sell.
Recognize that a buyer may not have the same risk exposure as you. Unrecorded tax liabilities may be a problem in negotiations, causing you to sacrifice some profit.
Also consider your client’s portability. If your client agreements prohibit transfer to another entity without consent, you will have to reach out to all before setting a purchase price.
RESEARCH & DEVELOPMENT TAX CREDITS.
Getting your financial house in order well before an ownership transition necessitates being savvy about opportunities to limit tax liability. The strategic use of R&D credits can lower liability significantly.
The R&D tax credit code was put in place in the 1980s and became permanent in 2015. Nearly all sectors of architecture and engineering qualify for the R&D Credit. You can claim the credit for employee and contractor costs associated with the following activities:
- Conceptual and schematic design
- Planning based on site conditions
- Design and evaluation of structural and mechanical building systems
- CAD modeling and simulation
- Design and development of MEP and HVAC systems
The time of everyone involved in these activities – architect, engineer, designer, project manager, partners and principals – will qualify as research activities.
You may have heard that the firm must be introducing a patent and developing something unique to qualify for this credit. The “discovery rule” was eliminated in the 2000s. As long as your company is developing or designing something new or improved and is going through a systematic trial and error process as part of the design or development, there’s a good chance your company qualifies.
You may have heard that a firm cannot claim this credit because it is being paid for the work. That also is false. There are some exceptions to this rule but, in general, fixed fee contracts are favorable for this credit calculation. Tax attorneys can help make sure you are only including expenses that qualify.
You may have heard that the firm must be profitable to use the credit. In 2015, the PATH Act expanded the R&D credit to small businesses. Now, new businesses can use the R&D credit to offset portions of their payroll tax. The R&D credit also carries forward for twenty years and can become a powerful asset to offset future tax liability, notably in the case of ownership transition.
MITIGATING THE IMPACT OF §174 EXPENSE AMORTIZATION.
Section 174 addresses research and experimental expenses. Those incurred by the taxpayer must be now amortized over five years, creating a gap in deduction starting in 2022, and an increase in tax liability for the next 5 years.
The R&D Credit can still be a great tool to reduce this liability and the 179D program can also help fill the gap. This deduction incentivizes architects and engineers who design or renovate energy efficient buildings owned by government or nonprofit organizations. As of 2023, the deduction can be up to $5.00/sf.
Finding extra deductions or credits will serve you now and when the time comes to transfer ownership.
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Will Swearingen is a principal & director of ownership transition with the Zweig Group.
Alexis Martin is CEO of EPSA USA, specializing in innovation funding.
Kevin Johns is a CPA with Clayton & McKervey specializing in accounting services for A/E clients.