New Year, New Role: Law Firm Partners Face Special Tax Considerations
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Every Jan. 1, many lawyers across the country add “I just made partner!” to their “Happy New Year!” wishes, since new partnerships often kick in at the start of year.
So the new year can mark the start of major financial changes for newly-minted equity partners, including important tax considerations that don’t concern law firm associates.
The promotion to co-ownership creates both responsibilities and opportunities, some of which have layers of complexity. Attorneys shouldn’t expect that all law firms will adequately prepare them for the tax implications of their transition to partner.
“Firms need to do a better job at this, so we often tell law firm leaders to bring in financial experts to offer advice, especially to senior associates and junior partners,” says Tom Clay, a law firm consultant with Altman Weil in Newton Square, Penn.
Ultimately, the responsibility rests with the individual attorney.
“Becoming a partner is the next step in a lawyer’s career, so you have to know what you’re getting into,” says Amy Drushal, a partner at Trenam Law in Tampa, Florida. “Although the firm has a responsibility to educate associates, it’s really up to the lawyer to understand the changes and act on them. A tax advisor can help out with that.”
The most apparent difference happens immediately when a new partner invests capital in the business. The amount of buy-in varies greatly among partnerships, but it’s usually sizable. Some new partners take out loans, and sometimes they’re paid buy-in money at the end of each year. Either way, planning is in order.
When the Taxman Cometh
A buy-in is only one element of change.
When you’re an employee, the law firm pulls money from your monthly salary to pay your portion of the Federal Insurance Contributions Act (FICA), Medicare and federal and state income taxes. But the firm won’t make these withholdings at the partnership level.
“You’re a partner, and it’s all on you,” says Clay.
So, you’ll need to figure out your quarterly estimated tax payments. Again, it’s best to get professional tax and financial planning counsel. Quarterly estimated tax payments often present cash-flow complexities because your taxable income may vary from quarter to quarter, unlike when you received a steady salary.
If you practice at a firm that has offices in multiple states, you may also owe taxes in them. (Read this article on nexus.) Drushal recalled a friend who practiced law in only one state, but the firm operated branches in eight — and her friend ended up paying taxes in all of them.
“It amounted to $50,000 a year. That wasn’t something she was fully prepared for,” Drushal says.
Other than for the partner’s state of residence, a multi-state firm may withhold state income taxes, and the new partner may need to decide whether to participate in composite returns, if the partnership files those.
State and federal income taxes aren’t the only new tax considerations that come with co-ownership: The income you report to the Internal Revenue Service (IRS) on a Form K-1 is subject to self-employment taxes. If your firm does international business and pays foreign taxes, you’ll need to keep abreast of your obligations to U.S. tax rules and limits to foreign tax credits.
The Good News
Tax complexities aside, what about a new partner’s tax opportunities?
As an employee, you’re limited in the amount you can itemize in your unreimbursed business expenses. A partner has more options and can deduct business costs as direct reductions of income for out-of-pocket expenses, such as professional dues and subscriptions, mileage, travel and other business-related costs. The deduction process can get tricky, so track your expenses carefully.
At many firms, partners can structure their ownership in ways that can lead to tax savings — like inserting a flow-through entity between partner and firm. The key is to set up these models correctly to reap the most benefits and comply with the law.
When you’re an associate, a chunk of your monthly salary probably goes into your 401(k) or other retirement account. The problem? There are only so many ways you can contribute to your retirement nest egg. As a partner, you have more options.
As an associate, you also encounter limits to what out-of-pocket health expenses you can deduct. But that limitation changes once you enter the partnership ranks: You can fully deduct the cash you spend on health insurance.
So, when you make partner, go ahead and lift a glass to your career — but promise yourself that on the next business day, you’ll call your tax advisor.