Tuesday, August 30, 2005

The Partnership Profit Allocations of Sin

The RothCPA blog calculates that the average per partner cost of the KPMG settlement with the government is $265,000. It assumes that there are 1600 partners who will share the loss. I think that these calculations are overly optimistic.

First, the amount to be paid is not tax deductible (the agreement with the government has an explicit provision to this effect). That means that, assuming an average 45% marginal rate (including federal and local income taxes and SECA, etc.), the total cash profits that KPMG must generate to have $456 Million in cash to pay the government is about $1 Billion. Assuming further that there are 1600 partners to share the burden, the firm must generate $625,000 in profits even before the partners see any cash to take home.

Second, however, the agreement with the government calls for KPMG to abandon certain lines of business altogether. Thus, it is logical to assume that there will be fewer than 1600 partners to share the burden. The number of partners will likely decrease even further in subsequent years (the amount is to be paid over 3 years) by defections and net attrition in the partnership ranks. (I suspect that loss in partnership ranks due to retirements will likely not be made up by younger people willing to become partners due to the sharp reversal in the value of a KPMG partnership position.) Assume that the average number of partners who will share the burden is 1400. In that case, the per partner profits needed to pay the settlement is over $714,000.

Add to this incredible burden the cost of dealing with the hugh number of claims, the loss of client base due to KPMG's tarnished image, the loss of profits due to the business lines that must be shed as part of the settlement agreement, the increased overhead due to the monitoring requirement imposed by the settlement agreement, and finally the reduction in the firm's productivity due to the pall that settles over it due to the battering that it will take, you can see the beginning of a death spiral.


Before anyone else points it out, there's an error in my calculations. I assumed a 45% marginal rate, but actually used a 55% marginal rate in the calculations. This is why I'm a tax lawyer, not a tax accountant.

In any event, applying the 45% marginal rate, the total cash profits necessary to generate the $456 Million settlement is about $829 Million. That amount, divided by 1600, results in a per partner burden of $518,125. Divided by 1400, the per partner burden is a little over $592,000.

I still think that KPMG is in death spiral territory, however.


Joe Kristan said...

Excellent points. It has also been pointed out (WSJ) that the actual number of partners is closer to 1525, so the starting number is 300K per partner.

I think it's more of a kick in the crotch rather than a death blow. While painful, KPMG will walk again. They have a secure membership in the audit oligopoly. While it hurts to lose a year's income, Sarbanes-Oxley and the limited competition for giant audits ensure a steady future cash flow for KPMG.

Mike said...

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Anonymous said...

Were the tax schemes sold by KPMG ever proven illegal? I don't think so. As an ex PMM tax person, I resent the Govt. doing an end run around the law by going after the partners when NO illegal tax scheme has been proven of judged wrong.