For many private practice lawyers, becoming a partner is a priority, yet it’s surprising how few are prepared for the financial implications of such an undertaking. In fact, many are woefully uninformed about what joining a law firm partnership really means—both in terms of the financial commitment they’re about to make and the personal wealth management it requires.
Becoming a partner in a law firm can be a transformative life experience. Becoming informed about the financial considerations contributes to a successful transition and partnership. Where to start? This month’s roundtable discussion includes an impressive team of financial experts exploring the important financial considerations all new law firm partners should consider.
Amy Adams (AA) — CPA is a senior tax manager for Sullivan, Bruyette, Speros & Blayney, Inc. She has more than 15 years of diversified experience within the tax and accounting industry providing tax compliance and tax advisory services. Before joining SBSB, she worked for KPMG in Bermuda for nine years. She is a member of the American Institute of Certified Public Accountants.
Jim Bruyette (JB) — Jim is co-founder and managing director of Sullivan, Bruyette, Speros & Blayney, Inc., a wealth management firm in McLean, Virginia, who provides personal financial planning, portfolio management, and income tax services to more than 150 law firm partners. Jim specializes in tax, investment and retirement planning for individuals and business clients. Jim has been included several times in Worth magazine’s list of “America’s Top Wealth Advisors.”
Mark Flanagan (MF) — Mark has been managing partner of McKenna Long & Aldridge LLP for 10 years, overseeing the firm’s financial and operational affairs. His law practice involves defending large corporations, small businesses and individuals in civil fraud and white-collar criminal cases. He joined the firm in 1988 after serving as a federal criminal prosecutor for the District of Columbia.
David A. Wexler (DW) — CLU, ChFC, AEP is a principle of Greenberg, Wexler & Eig, LLC, a member firm of the M Financial Group in Bethesda, Maryland. As a recognized authority on the use of life insurance in estate planning, succession planning and executive benefits, he has provided service to high net worth individuals, businesses and professional firms for more than 35 years. He is a past president of the Washington DC Estate Planning Council.
Darius Jenkins (DJ) — Darius is a mortgage loan officer with McLean Mortgage Corporation. Darius has more than 11 years’ experience in the mortgage industry. He is also a Certified Teacher for the Virginia Housing Development Authority and a past co-host for The Real Estate Hour on 1260WRC.
NG: What are the financial implications of becoming a partner in your law firm?
MF: As an initial question that pertains to most law firms, it is important to know whether you are an equity or non-equity partner. Most of the larger AmLaw firms have both categories of partners. The issues of how compensation is paid and what tax consequences may arise will vary significantly depending upon the category. Some firms also have partners that receive both an equity interest and a fixed compensation amount, which also will affect these issues including the timing of paying taxes. Additionally, if you are in a firm with offices in multiple states, you likely will owe taxes at the state level in all such states. Also, and very importantly, a new partner should carefully review the partnership agreement, which will address these issues as well. Finally, you need to know whether the law firm is a limited liability partnership (LLP, which most law firms are) or a limited liability company (LLC). LLPs and LLCs vary significantly in terms of their operations and structure.
JB: The move from law firm associate to equity partner entails significant change to a lawyer’s personal finances, which can be summarized in four areas:
- You will generally be required to make capital contributions to the firm
- Your personal tax return will become much more complicated as an equity partner
- You will receive access to a better package of employee benefits, but will need to pay for them yourself
- You become an owner in the law firm business, with all of the related benefits and risks.
NG: Starting with point a, what do new partners need to know about firm capital contributions? How much do they have to contribute, both on initial admission to the partnership and at any time in the future?
MF: If equity, the amount and time in which to pay it will vary significantly by firm, whether upon admission to the partnership or in the future. Typically, there will be an initial, more substantial payment at admission based on the equity interest you have, with additional payments annually if that interest increases (or payments back if it decreases).
NG: What if I don’t have the cash on hand to make my required capital contributions?
JB: Most firms have banking relationships that can be used to facilitate financing for your required capital contributions. However, keep in mind that these capital loans will usually require substantial monthly or quarterly payments, and even friendly bankers get grumpy when payments are missed.
DJ: Equity can be accessed by applying with your lender for a home equity line of credit, home equity loan, or refinancing your present property as a cash-out transaction. You should contact your lender for a mortgage analysis 6-12 months before actually needing the funds. That will enable you to understand how much of the equity you will be able to access, address any lending issues that may pertain to your financial and credit profile, and make the necessary changes if needed to qualify for the loan. What you don’t want to do is wait until you need the funds to apply for one of these loans only to discover that you don’t qualify at that time. Preparation is the key in the instance.
AA: Note that interest paid on a loan to fund your capital contributions qualifies as investment interest and can be deducted from partnership income annually to arrive at net taxable income.
NG: Am I entitled to interest on my capital contribution?
MF: Usually no, but there are exceptions.
JB: New partners need to recognize that capital contributions represent an equity stake in their law firm’s business. It should be viewed as a stock investment, not a loan, and the returns are generally received through annual distributions of your share of the entire firm’s profits rather than annual interest. If your firm is successful, it will likely be the best investment you will ever make.
NG: Moving on to point b, how will my income from the law firm be taxed once I make partner?
AA: The transition from employee to partner creates a host of additional compliance complexities. I highlight a few significant changes:
Self-employment taxes: In addition to federal and state taxes you are already subject to, your firm income (now reported on a Form K-1 instead of a Form W-2) is also subject to self-employment taxes at a rate of 15.3%. Don’t forget about the additional 0.9% Medicare tax imposed above certain thresholds, as implemented by the Affordable Care Act in 2013.
Estimated Tax Payments: In the absence of tax withholding, you are now required to make quarterly estimated tax payments. This presents issues related to tax and cash flow planning because income is typically not evenly earned and distributions may be sporadic or not representative of taxable income.
State Taxes: There is the potential for additional state tax return filings by either you personally or the partnership. You will make an election each year for the applicable states and this means you will need to determine when it is appropriate to participate in the company composite return or file your own nonresident state return instead. Participating in state composite returns typically requires additional reporting on your federal return for state tax deductions as well as credits on your resident state return. This will likely also require you to paper file your returns since attachments are commonly required to support payments made on your behalf by the firm.
Additional items: If your firm does business in foreign countries and pays foreign taxes, you may be subjected to the U.S. tax rules and limitations for foreign tax credits. If you are accustomed to filing your tax returns timely, you may now need to adapt to a broader timeline requiring extension in order to wait for the Form K-1 and allow adequate time to understand and complete the new intricacies of your filing obligations.
JB: it is very important for new partners to note that the move from W-2 withholdings to quarterly tax payments is a substantial complication that will require you to become adept at budgeting and cash flow planning. Most firms make quarterly distributions to their partners, but new partners need to make sure that the important priorities such as estimated tax, insurance premiums, and pension contributions are covered before you buy that new car!
NG: Speaking of insurance and pensions, how will these programs change once I become a partner?
MF: Usually, a partner will pay for all such benefits; in contrast, as a non-partner lawyer, the lawyer is an employee and the firm will be paying for part of the benefits (note that this answer also will vary significantly depending upon whether the firm is a LLP or LLC). Firms often will require partners to carry certain levels of insurance and also to participate in certain retirement programs, and it is important to understand any such provisions.
DW: The good news is you get more benefits. The bad news is you have to pay for all of them. Benefits vary from firm to firm and can be broken down into two broad categories: life insurance and retirement plans.
Long-term disability benefits are likely to increase significantly. However, unlike medical insurance, the premiums are not deductible. That being said, because partners are responsible for the premiums, any LTD is income tax free. Firm sponsored partner life insurance may be either group term life insurance or some form of group universal life insurance. The amount of coverage can be significantly higher than coverage for associates and, in some cases can be $1 million, $2 million, or more. Group universal life policies have two advantages over group term life. First, if you leave the firm, it is portable at the same rates available to the firm. Second, you have the option of putting additional cash into the policy to accumulate income tax-deferred cash value, making it possible to afford the coverage when you retire from the firm.
Retirement plans include qualified and non-qualified plans. Qualified plans are subject to ERISA non-discrimination and other statutory contribution and compensation limitation requirements. Qualified plan assets are held in a tax-exempt trust and are not subject to claims of firm or employee/partner creditors. Non-qualified retirement plans are not subject to ERISA nondiscrimination requirements or other statutory contribution and compensation limitation requirements. However, non-qualified plan assets are subject to the claims of firm creditors. There are two types of qualified retirement plans; defined contribution plans and defined benefit plans. A defined contribution plan may accept employee deferrals and employer contributions up to certain limits. A defined benefit plan actually states a specific benefit to be achieved by retirement and the annual contribution required to fund the stated retirement benefit is calculated annually based on an actuarial calculation that includes the amount of the benefit, the account balance, the number of years left until retirement and an assumed rate of return. Many law firm partners participate in both defined contribution and defined benefit plans allowing for significant pre-tax retirement plan savings and accumulation. Some firms also offer a non-qualified retirement benefit to partners. These plans provide supplemental retirement benefits in excess of the qualified plan benefits. Many firms have either frozen or eliminated these types of plans; however some still exist.
AA: These qualified plans are a significant benefit not available to employees and may be the biggest tax shelter available. You should take advantage of the high contribution limits and maximize them every year.
NG: Jim, you mentioned earlier that making equity partner is essentially equivalent to becoming a part owner of your firm’s business. What benefits and risks will this move entail?
JB: When you become an equity partner, your income will generally be greatly impacted by the financial performance of the entire firm, which can be great news or bad news. When a law firm fails the partners generally lose their capital contribution, so new partners need to make sure that they understand their firm’s financial standing and prospects for the future.
MF: I would advise all new partners to become educated on their firm’s governance and structure. As a starting point, you should review the partnership agreement to understand what it says about governance, operations and management. Additionally, you should review any policies or processes that may apply to important topics, such as partner compensation. Finally, you should have an understanding of what input you have as a partner into the policies and decisions the firm may make (e.g., under the partnership agreement, what matters are subject to a partnership vote?).
NG: If the firm doesn’t fail but loses money, is the new partner responsible?
MF: The answer will vary depending upon what category of partner you may be. For example, if you are an equity partner, your compensation will typically depend solely upon the financial performance of the firm in a given year, and if the firm comes in under what it is projecting at budget you will make less. That may or may not be the case if you are a non-equity partner.
NG: If I decide to leave the partnership do I get my capital contribution back?
MF: Again, the partnership agreement will address the terms governing eligibility for and repayment of capital. Typically, those terms provide for repayment in installments over a period of time.
NG: What other general financial planning issues should new law firm partners be aware of?
DW: Health insurance benefits that cover medical expenses, income replacement in the event of a disability, and long term care coverage are frequently adequate coverage for a new partner. However, private insurance coverage considerations are largely dependent on circumstances and your position in the life cycle. For a single new partner, the benefits are probably adequate because of having no responsibility for dependents or debt. However, a married partner with children should consider additional life insurance. In the event of a premature death, coverage would be used to pay off debts, finance private school education funding, college education funding and income for survivors, not to mention coordinating life insurance coverage with their estate planning. In addition, if a new partner has not acquired umbrella coverage as part of their homeowner’s policy, now would be a good time to consider adding this coverage.
DJ: Your ability to purchase a new home will depend on various factors. For example, what is the payment structure once you become a partner? Are you an equity partner, non-equity partner, what is the structure of the firm? What is your percentage of ownership in the firm? You may need to provide business tax returns in addition to your personal returns. You may be in a position where you have to wait two years to purchase or one year at a minimum. The key is preparation. Contact your lender, have an analysis done and create a plan for home ownership.
JB: As I mentioned earlier, your income could very well become much more sporadic throughout the year, with lower monthly draws and periodic larger profit distributions. You need to make sure that you have considered this in your monthly and annual budgeting, and also have lines of credit available in case you need help getting through the lean months between distributions.
In summary, we have mentioned several times that your financial life gets a lot more complicated once you make equity partner in your firm. If you don’t already have knowledgeable and trusted advisers available to help you manage the transition, you probably should find them now.
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