Should Your Firm Keep Two -- or More -- Sets of Books?

Most law firms operate as general partnerships, limited liability partnerships or limited liability companies (together, “partnerships”, whose members having capital in the firm herein are “partners”).

Does your partnership keep two sets of books ' or more? Al Capone kept two sets of books, and the judge sent him to the Federal Pen for doing so. Yet many law firms (and other professional businesses) legally keep two or more sets of books, arising from different accounting systems prescribed by 1) their partnership Agreements; 2) generally accepted accounting principles (GAAP) audited statements (which are required by some lenders and landlords), and 3) the tax laws. As a result, the firm's net assets ' and the partners' ownership of the law firm, as reflected in the partners' capital accounts ' may be substantially different under each set of books. Moreover, the amount and timing of the firm's cash distributions to partners, the amount of the partners' annual income taxes, and the availability and amount of bank loans to the firm may all be affected by the firm's applicable accounting methods ' all items that may substantially affect the partners' pocketbooks.

Let's analyze each type of accounting system ' the 'books' ' that the law firm may maintain, and how each may differ.

1. The 'books' under the Partnership Agreement. The Partnership Agreement (or operating agreement, in the case of a limited liability company) is the contract among the partners that sets forth their rights (including rights to share in the firm's income and to receive distributions) and their obligations. The firm's financial statements, when prepared in accordance with the provisions of the firm's Partnership Agreement, generally reflect both the firm's annual income and the partner's respective shares of that income.

Why are the books prepared in accordance with the provisions of the Partnership Agreement important? First, many firms provide that the firm's management is required to distribute out all of the firm's income (in some cases, reduced by reasonable reserves for working capital), as defined in the Partnership Agreement. The larger the firm's income, the more the partners get. Second, some firms provide that when a partner withdraws or retires from the firm, the amount paid to him will reflect the previously undistributed income allocated to him (in some cases including a portion of the current year's undistributed profits). Third, the partners often want to know whether the firm is becoming more profitable or less, and whether their own shares of income are increasing in absolute and relative terms; the computation of income under the Partnership Agreement typically is the measuring stick they use.

The partnership has substantial flexibility to adopt whatever accounting methods and approaches it chooses under the Partnership Agreement. Firms may adopt the cash or accrual method, or some hybrid of both. Some Partnership Agreements mandate that the books and computations of partnership income be done on the same accounting method and be the same amount determined for tax return reporting purposes ' thereby saving accounting fees since both sets of books will be the same!

Moreover, the accounting treatment of particular items can vary under the Partnership Agreement. For example, the depreciable lives of the firm's property and equipment (which directly affects annual depreciation expense and thereby annual net income) can be based on the lives used for purposes of GAAP; for tax reporting purposes (which are established by Congress and the IRS) or by any other method the partners agree to in their Partnership Agreement. Similarly, year-end prepaid rent and other expenses can be treated as deductible when paid (eg, in 2003) or deductible for the period to which they relate (ie, 2004), depending on what is provided for or permitted the Partnership Agreement (and the firm's permissible practices thereunder).

Similarly, for Partnership Agreement purposes the firm may select whatever fiscal year it desires (eg, January 31), even though it typically is required for tax purposes to use a calendar year end. These, and many other accounting decisions and elections under the Partnership Agreement, affect the 'bottom line' for each capital partner. The partners can agree to whatever type of accounting they wish ' but once stated in the Partnership Agreement, the firm's management must follow those provisions and practices or face potential consequences for failing to follow the Agreement.

2. The 'books' for GAAP accounting purposes. Third-party lenders to the firm and the firm's landlord may require the firm to submit annual financial statements prepared under GAAP, to better identify the assets and income of the firm, and to verify compliance with any covenants provided by the firm as to maintaining certain levels of assets, ratio coverage (of assets versus liabilities) or other financial benchmarks. GAAP may best be reflected by using the accrual method of accounting ' even if the firm uses the cash method for Partnership Agreement and tax purposes. The fiscal year used for GAAP purposes typically will be the fiscal year used under the Partnership Agreement.

3. The 'books' for tax reporting purposes. Finally, for federal and state tax reporting, the firm may use yet another method of accounting, a different method of determining depreciable lives and depreciation expenses, and a different fiscal year than those used for the other purposes listed above. For tax reporting purposes the firm generally is better off using the cash method of accounting, as it defers (until the following tax year) reporting into taxable income the firm's (hopefully) ever-growing accounts receivable. Because the firm generally can decide to timely pay (or prepay) expenses at year end, thereby generating deductible expenses in the current year, the combination of deferring income while accelerating expenses for tax purposes will generate the lowest taxable income for the current year ' something most partners strongly prefer. (This is less important in years when tax rates are decreasing; the opposite strategy may be appropriate when the decrease is substantial). See Sheldon I. Banoff, “When Partners' Tax Planning and Law Firm Objectives Collide,” LFPBR (Feb. 2002) page 1.

Of course, the tax 'books' must be prepared in accordance with the Internal Revenue Code and IRS rules and regulations. These mandate specified depreciable lives; prohibit deduction of certain client-reimbursable expenses, and allow limited elections (ie, limited flexibility) for certain other tax-related items. The tax rules also may mandate the partnership's use of a December 31 year-end for tax reporting purposes, even if the firm uses a different fiscal year for non-tax purposes. Finally, the tax rules will mandate treating withdrawn or retired partners as ongoing partners for tax purposes until they receive their last dollar of payments in liquidation of their partnership interests, even though they are no longer partners for state law purposes and are not reflected as partners for Partnership Agreement or GAAP accounting purposes. Treasury Regulation 1.736-1(a).

U.S. Form 1065 (Partnership Tax Return), page 4, requires the partnership to provide its balance sheet. Some firms use the 'tax basis books' accounts for this purpose; others use the Partnership Agreement books. Thus, confusion as to the different types of books (and the IRS' instructions to Form 1065) continues on.

In a future Law Firm Partnership and Benefits Report article, we will discuss the relevance of the partners' capital accounts under each of the multiple sets of books described in this article. As will be seen, among other things, a partner's capital account can affect the amount received when he or she withdraws from the firm or when the firm ultimately dissolves; determine the amount he or she may be personally liable for if there is a negative capital account balance upon withdrawal or the firm's dissolution; and affect the amount of taxable income or loss he or she recognizes upon these events.

Most law firms operate as general partnerships, limited liability partnerships or limited liability companies (together, “partnerships”, whose members having capital in the firm herein are “partners”).

Does your partnership keep two sets of books ' or more? Al Capone kept two sets of books, and the judge sent him to the Federal Pen for doing so. Yet many law firms (and other professional businesses) legally keep two or more sets of books, arising from different accounting systems prescribed by 1) their partnership Agreements; 2) generally accepted accounting principles (GAAP) audited statements (which are required by some lenders and landlords), and 3) the tax laws. As a result, the firm's net assets ' and the partners' ownership of the law firm, as reflected in the partners' capital accounts ' may be substantially different under each set of books. Moreover, the amount and timing of the firm's cash distributions to partners, the amount of the partners' annual income taxes, and the availability and amount of bank loans to the firm may all be affected by the firm's applicable accounting methods ' all items that may substantially affect the partners' pocketbooks.

Let's analyze each type of accounting system ' the 'books' ' that the law firm may maintain, and how each may differ.

1. The 'books' under the Partnership Agreement. The Partnership Agreement (or operating agreement, in the case of a limited liability company) is the contract among the partners that sets forth their rights (including rights to share in the firm's income and to receive distributions) and their obligations. The firm's financial statements, when prepared in accordance with the provisions of the firm's Partnership Agreement, generally reflect both the firm's annual income and the partner's respective shares of that income.

Why are the books prepared in accordance with the provisions of the Partnership Agreement important? First, many firms provide that the firm's management is required to distribute out all of the firm's income (in some cases, reduced by reasonable reserves for working capital), as defined in the Partnership Agreement. The larger the firm's income, the more the partners get. Second, some firms provide that when a partner withdraws or retires from the firm, the amount paid to him will reflect the previously undistributed income allocated to him (in some cases including a portion of the current year's undistributed profits). Third, the partners often want to know whether the firm is becoming more profitable or less, and whether their own shares of income are increasing in absolute and relative terms; the computation of income under the Partnership Agreement typically is the measuring stick they use.

The partnership has substantial flexibility to adopt whatever accounting methods and approaches it chooses under the Partnership Agreement. Firms may adopt the cash or accrual method, or some hybrid of both. Some Partnership Agreements mandate that the books and computations of partnership income be done on the same accounting method and be the same amount determined for tax return reporting purposes ' thereby saving accounting fees since both sets of books will be the same!

Moreover, the accounting treatment of particular items can vary under the Partnership Agreement. For example, the depreciable lives of the firm's property and equipment (which directly affects annual depreciation expense and thereby annual net income) can be based on the lives used for purposes of GAAP; for tax reporting purposes (which are established by Congress and the IRS) or by any other method the partners agree to in their Partnership Agreement. Similarly, year-end prepaid rent and other expenses can be treated as deductible when paid (eg, in 2003) or deductible for the period to which they relate (ie, 2004), depending on what is provided for or permitted the Partnership Agreement (and the firm's permissible practices thereunder).

Similarly, for Partnership Agreement purposes the firm may select whatever fiscal year it desires (eg, January 31), even though it typically is required for tax purposes to use a calendar year end. These, and many other accounting decisions and elections under the Partnership Agreement, affect the 'bottom line' for each capital partner. The partners can agree to whatever type of accounting they wish ' but once stated in the Partnership Agreement, the firm's management must follow those provisions and practices or face potential consequences for failing to follow the Agreement.

2. The 'books' for GAAP accounting purposes. Third-party lenders to the firm and the firm's landlord may require the firm to submit annual financial statements prepared under GAAP, to better identify the assets and income of the firm, and to verify compliance with any covenants provided by the firm as to maintaining certain levels of assets, ratio coverage (of assets versus liabilities) or other financial benchmarks. GAAP may best be reflected by using the accrual method of accounting ' even if the firm uses the cash method for Partnership Agreement and tax purposes. The fiscal year used for GAAP purposes typically will be the fiscal year used under the Partnership Agreement.

3. The 'books' for tax reporting purposes. Finally, for federal and state tax reporting, the firm may use yet another method of accounting, a different method of determining depreciable lives and depreciation expenses, and a different fiscal year than those used for the other purposes listed above. For tax reporting purposes the firm generally is better off using the cash method of accounting, as it defers (until the following tax year) reporting into taxable income the firm's (hopefully) ever-growing accounts receivable. Because the firm generally can decide to timely pay (or prepay) expenses at year end, thereby generating deductible expenses in the current year, the combination of deferring income while accelerating expenses for tax purposes will generate the lowest taxable income for the current year ' something most partners strongly prefer. (This is less important in years when tax rates are decreasing; the opposite strategy may be appropriate when the decrease is substantial). See Sheldon I. Banoff, “When Partners' Tax Planning and Law Firm Objectives Collide,” LFPBR (Feb. 2002) page 1.

Of course, the tax 'books' must be prepared in accordance with the Internal Revenue Code and IRS rules and regulations. These mandate specified depreciable lives; prohibit deduction of certain client-reimbursable expenses, and allow limited elections (ie, limited flexibility) for certain other tax-related items. The tax rules also may mandate the partnership's use of a December 31 year-end for tax reporting purposes, even if the firm uses a different fiscal year for non-tax purposes. Finally, the tax rules will mandate treating withdrawn or retired partners as ongoing partners for tax purposes until they receive their last dollar of payments in liquidation of their partnership interests, even though they are no longer partners for state law purposes and are not reflected as partners for Partnership Agreement or GAAP accounting purposes. Treasury Regulation 1.736-1(a).

U.S. Form 1065 (Partnership Tax Return), page 4, requires the partnership to provide its balance sheet. Some firms use the 'tax basis books' accounts for this purpose; others use the Partnership Agreement books. Thus, confusion as to the different types of books (and the IRS' instructions to Form 1065) continues on.

In a future Law Firm Partnership and Benefits Report article, we will discuss the relevance of the partners' capital accounts under each of the multiple sets of books described in this article. As will be seen, among other things, a partner's capital account can affect the amount received when he or she withdraws from the firm or when the firm ultimately dissolves; determine the amount he or she may be personally liable for if there is a negative capital account balance upon withdrawal or the firm's dissolution; and affect the amount of taxable income or loss he or she recognizes upon these events.