Understanding Your New Financial Responsibilities as a Partner in a Law Firm

Congratulations, You Made Partner! Now what? 

You’ve put in the hard work and have become a partner at your law firm! This is a significant milestone in any attorney’s career. As you settle into your new role, you may be surprised by the many differences between being a partner and an employee of a law firm. You will now be faced with an entirely new set of financial implications. Careful planning will help you navigate this new landscape. Let’s break down what you need to know to protect and grow your investment.

Understanding Your New Financial Responsibilities

How to Fund Your Buy-In

One of the first things you’ll need to consider is how you’ll fund the buy-in to the partnership. Some firms offer loan options to help finance this payment, while others may have relationships with banks that offer capital account loans.

You should consider this an investment in the partnership and your future. Be sure to take the time to consider your options and plan your financial strategy. You want this newfound partnership to be worth your time and money while considering potential risks. Remember that the interest on these loans is usually tax-deductible, which affects your net after-tax cash flow.

Adjusting to a New Income Structure

As you move from employee to partner, your paycheck structure will change. Instead of receiving a paycheck with taxes and other withholdings deducted, you’ll most likely receive a semi-monthly or monthly draw. This means you’ll be responsible for withholding and paying your federal, state, Medicare, and Social Security taxes and making quarterly estimated tax payments to the IRS and any applicable state agencies.

Tax planning and cash management are essential to avoid any unwelcome surprises. As a partner, it’s your responsibility to plan for your quarterly tax estimates. Many partnerships issue quarterly tax distributions to help their partners cover their tax obligations. However, they do not always equal the taxes you may owe. It’s worth noting that distributions not used for current tax payments should be saved, and don’t assume you don’t need to save extra cash for taxes.

You may also have new state tax requirements if your partnership has income attributable to other states.  You are now being allocated your share of the partnership income, so if your firm does business in other states, you may need to pay taxes to those states and as well as the state you live in. You will likely get at least partial credit in your home state for taxes paid to other states, but possibly not full credit.  Some firms will pay part or all these taxes to other states on behalf of their partners. treating the payments as an additional draw. You will want to discuss any possible state tax options with your tax preparer before making any elections with your partnership.

You may also have foreign reporting obligations if your firm does work in other countries.

Your New Reporting Structure

As an equity partner, you will most likely receive a Schedule K-1 rather than a W2. This form will reflect your share of the partnership income and expenses. It will also show you the tax basis in your partnership account.  Remember, this is an investment, and you will want to understand how much your investment is worth if you decide to leave or eventually retire.

You may also notice that the income you are being taxed on differs from the distributions you received. The reason behind this is the distinction between taxable income and distributable income. Taxable income is the amount reported to you on your K-1 and the amount on which you will pay taxes.  Distributable income will be the amount of cash you receive from the partnership.

Understanding the Tax Deductions You Can Take Advantage of

You can take many new tax deductions since you are now considered a self-employed partner.

The biggest deduction you can take is for your contributions to retirement plans. You may be able to contribute up to 25% of your income to a retirement plan each year; you are not limited to the maximum 401(K) amount. Typically, the partnership controls the type of plan and amount you must contribute, but this is fully deductible against your partnership income. If your firm requires you to contribute a certain amount, you will want to plan for this.

Health insurance is another deduction you can take. Your premiums may be higher now but are fully tax deductible. You may also be eligible to contribute to a high-deductible health savings account (HSA).

If you took out a loan to cover your buy-in, remember the interest paid is deductible.

Finally, any out-of-pocket expenses that the firm did not reimburse are now deductible since you are now considered self-employed.

Your Financial Future

Whether you just made partner or are joining a partnership, this is a new chapter in your career. Planning is critical to managing these added responsibilities of being a partner. By focusing on proactive tax planning, you’ll avoid potential financial pitfalls and ensure that your investment in the partnership continues to thrive. Mary Joyce and the Friedman + Huey team can help you navigate these decisions to help you make the right financial choices.