An introduction to financial planning for equity partners
Congratulations! If you are an attorney working for a top-tier law firm or a senior tax professional working for one of the big four accounting firms, becoming an equity partner is the summit you set out to reach when you passed the bar or the CPA exam.
Of course, you probably didn’t realize how many billable hours you would have to log or how many “weekend” projects you needed to get done that somehow materialized on a Friday.
While great from a career standpoint, becoming a partner impacts your financial outlook both in the short and long term. The good news is that as your compensation increases, you will have the opportunity to do two things: enhance your lifestyle and save aggressively toward a time when you don’t have to work or work as hard. We like to call this Vocational Freedom. To get there, you will need a solid plan in place.
What to Expect When You Reach Partner
To start, you should review and make yourself familiar with your firm’s partnership agreement. There you will find clarity on important topics such as compensation, structure, management, etc.
It is essential for you to understand what your firm offers to partners. For law firms, there are usually two types of partnership models: single-tier and two-tier. Today, most firms use a two-tier partnership model where a senior associate is elevated to either a non-equity partner or a full equity partner.
Non-equity partners are salaried and do not get an ownership interest in the firm like equity partners. Firms often use the non-equity partnership structure to reward their senior associates with the title without diluting the firm’s ownership pool.
How the Move Affects Your Personal Finances
The move from senior associate to full equity partner has a significant impact on a lawyer’s personal finances. Below are five main areas:
- You will be required to make capital contributions to the firm
- Your tax return will have much more complexity
- You will need to pay for your own benefits, but those benefits may be better overall
- You are an owner in the law firm, with all the benefits and risks that come with that reality
- Your overall financial plan should include an appropriate asset allocation for increased cash flow and any updates or changes to your estate plan
Considering the above, if a full equity partner is where you land, there are additional questions you should ask to have a better understanding of partnership at your firm:
- Is the firm an LLC or LLP? There are differences in liability for debt and negligence by other members or partners
- Will you be receiving a draw or a draw along with fixed compensation?
- How is each partner’s draw determined, and how often do partners receive their draws?
- How much in capital contributions will you need to make, and when?
- Will the partnership affect your benefits, and how much will they cost?
Equity partnerships come with an obligation to purchase the partnership via a capital contribution to your firm. Depending on the firm, capital contributions generally range from 15 to 30 percent of the partner’s annual profits.
Most firms give new partners time to pay the initial capital contribution, ranging from 1-3 years. In most cases, the firm has an existing banking relationship with terms to allow new partners to finance their contribution. A lump-sum contribution or deduction from your draws is also allowable in most cases.
Your firm’s partnership agreement will outline the terms of eligibility of repayment upon your departure from the firm.
When you become an equity partner, you move from being a W-2 employee to a K-1 owner. As an owner, your firm does not withhold taxes on your income. You need to make sure that you allocate sufficient cash flow to cover quarterly tax payments. These estimated tax payments are straight forward and are usually equal payments when you are a non-equity partner.
Paying estimated taxes based on taxable earnings of the firm is something full equity partners must do. Your firm usually provides partners with all the data to calculate the payments. In this case, the payments should align with the firm’s earnings per quarter instead of being equal. Equity partners do run the risk of overpaying if they don’t collaborate with their tax professional to synch these payments.
Other things to know:
- You will need to file in every state in which your firm conducts business
- This can be done using a state composite tax return
- For high-tax states like New York and California, you may want to opt-out
- You can deduct the interest you pay on the loan for your capital contribution
- You can deduct health insurance premiums paid
Many law firms offer defined contribution and defined benefit plans to partners. These plans provide significant pre-tax retirement savings. For 2020, defined contribution plans allow partners to contribute up to $57,000 annually. If your firm offers a cash balance plan, your contribution can be well into the six figures.
Some firms match these plans with 401(k) plans. These plans are hybrids between a defined benefit plan and a defined contribution plan.
Holistic Financial Planning for Equity Partners
Current equity partners and soon-to-be equity partners usually do not have the time to deal with all the complications and moving pieces that go along with making the jump to ownership.
It is vital that you align yourself with other professionals who can assist you in navigating these new waters. A tax professional and a financial advisor are an excellent place to start.
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