Congratulations, you have been named a partner at your law firm. If you have joined a big law firm, this may have been your goal from the day you began, the reason that you sacrificed nights and weekends to bill 2,000-plus hours each year, the reason that you have quietly and competently completed your work even when it was dropped on your desk on 5:30 p.m. on a Friday evening by a senior partner with a Monday morning deadline. Well, now you are partner, and you’ve earned it.
Becoming a partner can impact your financial plan today and in the future. Below we have outlined potential changes and their significance regarding your personal financial plan. (Note: this applies to equity partnership. Non-equity partners experience significant changes as well, but those are not addressed in this summary).
As an associate, you were likely paid as an employee; you received a salary via W-2 compensation. As a partner you own part of a business; you may receive little to no wages for the remainder of your career as partner. Money makes its way into your personal bank account via draws, quarterly, or annual distributions. What does that mean for your taxes?
Partners in a typical LLP or LP receive a Form K1 rather than a Form W2 to indicate amount of income earned in a given year. In addition to your normal federal and state taxes, you may pay a self-employment tax (15.3%) that covers your annual contribution to Social Security and Medicare.
Most of the time, you no longer withhold for federal and state taxes every pay period. Instead, you could be required to make estimated payments each quarter. These payments will be significant, and require an effective cash management plan or budget for your personal financial affairs.
- Capital Contributions:
Your previous work as an associate has earned you the opportunity to become a partner, or more accurately, purchase partnership in the firm. This means you will need to make a capital contribution to the firm. Said another way, you now need to buy an interest in your firm. Initial contributions can be costly and vary based on the firm you are joining. Ultimately in a partnership, you are purchasing rights to a share of the firm’s annual profits. We say “initial contributions” because you may have an opportunity to make additional capital contributions to purchase additional shares of the partnership. Or, in the unfortunate circumstances when your firm has poor year(s), you may be required to make contributions to fund a shortfall in the firm’s cash flow.
New partners can make these contributions, either through a lump-sum payment (if you have the cash on hand) or though financing. Often a firm has a banking relationship that offers terms to finance your capital contributions over five or seven years, with interest. If you own a home with equity, you can use a home equity line of credit or a cash-out refinance to make your initial contribution. There are several ways to make this contribution and it is important to find the method that best suits your personal circumstances.
- Human Capital:
The preceding changes to your financial life are immediate and important. Borrowing large sums of money to purchase a partnership percentage can stressful. Making your first estimated payment may alter your political stance and can be difficult to budget. However, becoming a partner has biggest impact on your long-term financial independence and your ability to earn higher income.
As a partner, your income can be determined by the amount of business (revenue) you originate and the profitability of the firm. Each firm has their own method of determining your annual partnership share or distribution, but most are a formula of factors in three main categories; 1) the amount of revenue you personally originate, 2) the amount of hours you bill personally (for your client or for someone elses), 3) and the profitability of the firm. Each of these is important, but if you can originate more business for the firm, your income will increase in-kind.
Most associates and partners know that partners can and do earn more money (no shock here). The key to long term financial success is converting a portion of this income growth in to assets for the future. As your income increases you have the opportunity to do two things – expand your lifestyle or save for financial independence (the point at which you have accumulated enough assets to support your lifestyle indefinitely… another topic) – those with sound financial plans do both.