Partnership Investments

3) The law firm itself, whose leadership believes that successful joint investments of monies will strengthen the institutional ties (and retention) of its partners.

Still another source of 'investments' arising from law partnerships is the receipt of stock or other equities in clients in lieu of cash fees for services. That type of 'investment,' most popular during the dot.com days, is beyond the scope of this article. See Sheldon I. Banoff, 'When Can Law Firms and Lawyers Accept Stock or Stock Options for Services?' Law Firm Partnership & Benefits Report, August 2000, and 'When Should Law Firms and Lawyers Retain Stock or Stock Options for Services?' Law Firm Partnership & Benefits Report, July 2001.

For purposes of this discussion, let's assume that a substantial number of your law firm's members are interested in pooling their monies to make one or more investments. Who should decide what investments are made? How should the investment be structured? What are the potential tax and non-tax consequences to the firm and its partners with respect to the ongoing ownership and ultimate sale or other disposition of the investment? Should the investment be owned inside or outside the law firm? What ethical or legal restrictions affect the partners' ability to invest jointly? Finally, is it a good or a bad thing for the law firm itself if the partners are making investments as described above ' even if the investments are successful?

In some situations, if investment is done inside the firm, the analysis will be affected by the law firm's legal structure (i.e., as a general partnership, limited liability partnership (LLP), limited liability company (LLC), professional corporation (PC) or professional association (PA)) and by the law firm's status for tax purposes (i.e., taxed as a partnership, C corporation, or S corporation).

For discussion purposes, let's assume law firm ABC, an LLP that is taxed as a partnership, has several partners willing to making joint investments, either inside or outside the firm. Two types of investment opportunities come to the partners' attention: 1) an investment in a client's new company, which is quite risky but has huge upside potential, and 2) the partners wish to create a fund that invests in several other funds for diversification purposes, with a committee of the partners choosing the appropriate funds and amount of investment or commitment level. The partners discuss the alternatives, and conclude that some partners would be interested in investing in both opportunities, while others might invest in either one or none.

A critical issue that the firm and its partners must consider is: Should the investments be made by the law firm itself, by a separate entity, or by each individual directly? There is no clear answer that applies in all cases. Some law firms that invest in client ventures retain the equity (indefinitely) within the firm until the venture's ultimate sale or liquidation. Such retention assures the firm's management of control over the ownership and disposition of the equity. It also may provide the client with greater evidence of the firm's ongoing involvement with, and commitment to, the client. Retention of the equity within the firm may better assure compliance with applicable securities law restrictions or contractual agreements relating to ownership of client securities. If potential philosophical or actual conflicts between the client and the firm necessitate disposal of the client equity, the firm may be in a better position to do so quickly if it directly owns and controls the investment. Finally, with respect to illiquid entities, the firm may be in a better position to negotiate a voice in the management of the investment (if so desired) and be in a better position to negotiate a sale at a price superior to that which the firm's individual partners may be able to obtain.

Retaining the client equities inside the firm also may have disadvantages. The optimum time for the firm to sell its client equity may be a sensitive time from the client's viewpoint; like some sales of stock by a corporation's own directors, the firm's sale may be viewed as a vote of 'no confidence.' Also, if the client equity's value increases substantially, reflection of the investment on the firm's financial statements at its fair market value may cause internal dissention between those respective partners who do and those who do not share in the client equity's appreciation (which in turn depends on the matter in which the firm allocates the gains, cash flow, and sales proceeds from the client investment among its partners).

The latter issues should not be underestimated. Because partners' ownership within the firm may change from year to year, and partners may join or leave the firm while the partnership continues to own the investment, hard choices must be made as to whether the investment is to be allocated solely among those who are partners at the time of the investment, or (if the investment is made with the law firm's own money) by the firm itself. Moreover, assuming the investment is illiquid, it may be necessary for the firm to continue allocating a portion of the investment to partners who have withdrawn from the law firm's practice (whether due to retirement, death, or to compete with the firm). The tax laws will continue to treat the former partners as partners for tax purposes, until they receive their final payments from the law firm (including any investments therein), even if such occurs many years after they withdraw from the partnership under state law. Thus, the firm may find itself having reporting and communications with former partners (some of whom may have left acrimoniously); retired partners; divorced spouses; and heirs of decedent partners (including spouses, children, and trustees of testamentary trusts) who had little or nothing to do with the law firm itself when the investment was made.

Dealing with the special tax and non-tax problems of partners who join or leave the firm while the investment is owned within the partnership are beyond the scope of this article.

Some investments require additional capital to be contributed at future times, by design or otherwise. If the partnership owns the investment and is obligated to meet the additional capital call, will such be paid out of current funds, or will the partners who benefited from the original investment be required to make the contribution? What if the original group does not make the full contribution? If it is paid out of current year's firm revenues, then the current year's partners should obtain the benefit of partial ownership. How should that be determined, and who will act as referee between the original investor partners and the new partners?

The allocation of the profits and losses from the investments within the firm need not be made in the same ratios as the firm's allocations of its law practice profits each year. Separate accounting is permissible and generally will be respected for tax purposes. However, the separate accounting raises some costs and complexities.

The retired partners of one law partnership that made investments ran into an unanticipated tax problem in connection with their firm's nonqualified retirement payments to them, solely due to their investment partnership's profits. In Letter Ruling 200403056, the IRS ruled that a law firm's lifetime payments to its retired partners under its non-qualified retirement program were not excluded from net earnings from self-employment (and thus were subject to annual self-employment taxes) because the partners continued to participate in the firm's investment program. The ruling does not indicate there will be any di minimus exception, and thus it appears that even a small participation interest in a firm investment program inside the law firm would preclude the retired partner from avoiding self-employment tax in such a situation.

Some planning solutions exist to avoid this tax problem, including distribution of the investment out to the retired partner, if permissible. This self-employment tax issue would not arise if the investment instead was made outside of the partnership, and only the retirement benefits were paid from the partnership to the former partner.

One other risk of ownership of investments inside the partnership: The bankruptcy of the law firm, albeit highly unlikely, might cause the investments to be directly at risk. If instead the investment was made outside of the partnership, and assuming the investment entity is respected as an entity separate from the firm for creditor-protection purposes, the firm's bankruptcy presumably would not effect the partners' investments.

There are advantages and issues with respect to the investment being acquired by an investment entity (typically an LLC) owned by those partners who wish to make the investments. Most firms' investment entities are purely voluntary; moreover, those partners who participate may have ownership percentages in the investments that are substantially different from their percentage ownership of the firm itself. Those partners who are more risk adverse can avoid or reduce their participation in the investment if they so desire.

A potential point of tension between those who invest and those who don't: The investment entity will incur the record-keeping and administrative burdens of maintaining ownership positions in what may be numerous client equities or funds. If the same firm personnel are required to undertake these administrative functions and the investment entity does not fully reimburse the firm for use of the latter's personnel and other costs (e.g., preparation of federal and state tax returns and organizational and ongoing legal costs), there may be friction between those partners in the firm who participate in the investment entity and those who do not. On the other hand, if the client equities substantially appreciate, ownership of the equities outside the law firm likely will reduce the specter of dissention among those respective partners who do and do not share in the proceeds of those equities.

A number of administrative issues arise, regardless of whether the investment is inside or outside the firm. Capital calls (including prior commitments which must be funded on short notice) require all of the partners to ante up their cash on a timely basis; what will the partners' investment fund do if one or more partners refuses to meet his or her obligation? Will the firm advance the monies? Will the managers of the LLC front the cash?

Secondly, investment activities through pass-through entities may result in delays in filing tax returns (while each level of ownership awaits the K-1 tax forms from the operating partnerships or LLCs), including the law firm partners. Moreover, if the underlying funds (also taxable as partnerships) own properties in other states, there may be the need for multi-state tax return filings by the investment entity and its partners, even though the allocable amounts of taxable income or loss are relatively small on a partner-by-partner investor basis for each state. Many of the tax and non-tax issues that partnerships and LLCs face in making investments will arise, regardless of whether the investment is inside or outside of the partnership. Input from sophisticated tax and partnership/LLC counsel is advised.

Sheldon I. Banoff, P.C. is a partner in the Chicago office of Katten Muchin Rosenman LLP. His expertise includes general tax and partnership matters, and counseling professional firms. He can be reached at 312-902-5256 or [email protected].

With profits per partner continuing to rise, many attorneys have more discretionary income available for investment. In addition to investing directly in both traditional and nontraditional sources, some partners may also choose to invest (either inside or outside their law firms) in opportunities that arise in the law firm setting. Sources of investment opportunities include:

1) Firm clients, some of whom may expect their law firms and other professionals to actively invest in their new activities (e.g., a stock or securities offering or hedge fund), as a sign of support;

2) A partner, who in turn obtains the investment opportunity from a third party (e.g., a financial adviser to a client, or the client himself). Many partnership agreements provide that any investment opportunities made available to a partner by a client must be offered to and shared with other partners of the firm; and

3) The law firm itself, whose leadership believes that successful joint investments of monies will strengthen the institutional ties (and retention) of its partners.

Still another source of 'investments' arising from law partnerships is the receipt of stock or other equities in clients in lieu of cash fees for services. That type of 'investment,' most popular during the dot.com days, is beyond the scope of this article. See Sheldon I. Banoff, 'When Can Law Firms and Lawyers Accept Stock or Stock Options for Services?' Law Firm Partnership & Benefits Report, August 2000, and 'When Should Law Firms and Lawyers Retain Stock or Stock Options for Services?' Law Firm Partnership & Benefits Report, July 2001.

For purposes of this discussion, let's assume that a substantial number of your law firm's members are interested in pooling their monies to make one or more investments. Who should decide what investments are made? How should the investment be structured? What are the potential tax and non-tax consequences to the firm and its partners with respect to the ongoing ownership and ultimate sale or other disposition of the investment? Should the investment be owned inside or outside the law firm? What ethical or legal restrictions affect the partners' ability to invest jointly? Finally, is it a good or a bad thing for the law firm itself if the partners are making investments as described above ' even if the investments are successful?

In some situations, if investment is done inside the firm, the analysis will be affected by the law firm's legal structure (i.e., as a general partnership, limited liability partnership (LLP), limited liability company (LLC), professional corporation (PC) or professional association (PA)) and by the law firm's status for tax purposes (i.e., taxed as a partnership, C corporation, or S corporation).

For discussion purposes, let's assume law firm ABC, an LLP that is taxed as a partnership, has several partners willing to making joint investments, either inside or outside the firm. Two types of investment opportunities come to the partners' attention: 1) an investment in a client's new company, which is quite risky but has huge upside potential, and 2) the partners wish to create a fund that invests in several other funds for diversification purposes, with a committee of the partners choosing the appropriate funds and amount of investment or commitment level. The partners discuss the alternatives, and conclude that some partners would be interested in investing in both opportunities, while others might invest in either one or none.

A critical issue that the firm and its partners must consider is: Should the investments be made by the law firm itself, by a separate entity, or by each individual directly? There is no clear answer that applies in all cases. Some law firms that invest in client ventures retain the equity (indefinitely) within the firm until the venture's ultimate sale or liquidation. Such retention assures the firm's management of control over the ownership and disposition of the equity. It also may provide the client with greater evidence of the firm's ongoing involvement with, and commitment to, the client. Retention of the equity within the firm may better assure compliance with applicable securities law restrictions or contractual agreements relating to ownership of client securities. If potential philosophical or actual conflicts between the client and the firm necessitate disposal of the client equity, the firm may be in a better position to do so quickly if it directly owns and controls the investment. Finally, with respect to illiquid entities, the firm may be in a better position to negotiate a voice in the management of the investment (if so desired) and be in a better position to negotiate a sale at a price superior to that which the firm's individual partners may be able to obtain.

Retaining the client equities inside the firm also may have disadvantages. The optimum time for the firm to sell its client equity may be a sensitive time from the client's viewpoint; like some sales of stock by a corporation's own directors, the firm's sale may be viewed as a vote of 'no confidence.' Also, if the client equity's value increases substantially, reflection of the investment on the firm's financial statements at its fair market value may cause internal dissention between those respective partners who do and those who do not share in the client equity's appreciation (which in turn depends on the matter in which the firm allocates the gains, cash flow, and sales proceeds from the client investment among its partners).

The latter issues should not be underestimated. Because partners' ownership within the firm may change from year to year, and partners may join or leave the firm while the partnership continues to own the investment, hard choices must be made as to whether the investment is to be allocated solely among those who are partners at the time of the investment, or (if the investment is made with the law firm's own money) by the firm itself. Moreover, assuming the investment is illiquid, it may be necessary for the firm to continue allocating a portion of the investment to partners who have withdrawn from the law firm's practice (whether due to retirement, death, or to compete with the firm). The tax laws will continue to treat the former partners as partners for tax purposes, until they receive their final payments from the law firm (including any investments therein), even if such occurs many years after they withdraw from the partnership under state law. Thus, the firm may find itself having reporting and communications with former partners (some of whom may have left acrimoniously); retired partners; divorced spouses; and heirs of decedent partners (including spouses, children, and trustees of testamentary trusts) who had little or nothing to do with the law firm itself when the investment was made.

Dealing with the special tax and non-tax problems of partners who join or leave the firm while the investment is owned within the partnership are beyond the scope of this article.

Some investments require additional capital to be contributed at future times, by design or otherwise. If the partnership owns the investment and is obligated to meet the additional capital call, will such be paid out of current funds, or will the partners who benefited from the original investment be required to make the contribution? What if the original group does not make the full contribution? If it is paid out of current year's firm revenues, then the current year's partners should obtain the benefit of partial ownership. How should that be determined, and who will act as referee between the original investor partners and the new partners?

The allocation of the profits and losses from the investments within the firm need not be made in the same ratios as the firm's allocations of its law practice profits each year. Separate accounting is permissible and generally will be respected for tax purposes. However, the separate accounting raises some costs and complexities.

The retired partners of one law partnership that made investments ran into an unanticipated tax problem in connection with their firm's nonqualified retirement payments to them, solely due to their investment partnership's profits. In Letter Ruling 200403056, the IRS ruled that a law firm's lifetime payments to its retired partners under its non-qualified retirement program were not excluded from net earnings from self-employment (and thus were subject to annual self-employment taxes) because the partners continued to participate in the firm's investment program. The ruling does not indicate there will be any di minimus exception, and thus it appears that even a small participation interest in a firm investment program inside the law firm would preclude the retired partner from avoiding self-employment tax in such a situation.

Some planning solutions exist to avoid this tax problem, including distribution of the investment out to the retired partner, if permissible. This self-employment tax issue would not arise if the investment instead was made outside of the partnership, and only the retirement benefits were paid from the partnership to the former partner.

One other risk of ownership of investments inside the partnership: The bankruptcy of the law firm, albeit highly unlikely, might cause the investments to be directly at risk. If instead the investment was made outside of the partnership, and assuming the investment entity is respected as an entity separate from the firm for creditor-protection purposes, the firm's bankruptcy presumably would not effect the partners' investments.

There are advantages and issues with respect to the investment being acquired by an investment entity (typically an LLC) owned by those partners who wish to make the investments. Most firms' investment entities are purely voluntary; moreover, those partners who participate may have ownership percentages in the investments that are substantially different from their percentage ownership of the firm itself. Those partners who are more risk adverse can avoid or reduce their participation in the investment if they so desire.

A potential point of tension between those who invest and those who don't: The investment entity will incur the record-keeping and administrative burdens of maintaining ownership positions in what may be numerous client equities or funds. If the same firm personnel are required to undertake these administrative functions and the investment entity does not fully reimburse the firm for use of the latter's personnel and other costs (e.g., preparation of federal and state tax returns and organizational and ongoing legal costs), there may be friction between those partners in the firm who participate in the investment entity and those who do not. On the other hand, if the client equities substantially appreciate, ownership of the equities outside the law firm likely will reduce the specter of dissention among those respective partners who do and do not share in the proceeds of those equities.

A number of administrative issues arise, regardless of whether the investment is inside or outside the firm. Capital calls (including prior commitments which must be funded on short notice) require all of the partners to ante up their cash on a timely basis; what will the partners' investment fund do if one or more partners refuses to meet his or her obligation? Will the firm advance the monies? Will the managers of the LLC front the cash?

Secondly, investment activities through pass-through entities may result in delays in filing tax returns (while each level of ownership awaits the K-1 tax forms from the operating partnerships or LLCs), including the law firm partners. Moreover, if the underlying funds (also taxable as partnerships) own properties in other states, there may be the need for multi-state tax return filings by the investment entity and its partners, even though the allocable amounts of taxable income or loss are relatively small on a partner-by-partner investor basis for each state. Many of the tax and non-tax issues that partnerships and LLCs face in making investments will arise, regardless of whether the investment is inside or outside of the partnership. Input from sophisticated tax and partnership/LLC counsel is advised.

Sheldon I. Banoff, P.C. is a partner in the Chicago office of Katten Muchin Rosenman LLP. His expertise includes general tax and partnership matters, and counseling professional firms. He can be reached at 312-902-5256 or [email protected].