Helping Associates Transition to Partnership

So, you have given your associate the good news ' she has just been elected a partner of the firm. Congratulations. Now, it's time to talk about what this means for your new partner from a financial perspective, especially during his or her first few years as a partner.

Unfortunately, too many firms fail to prepare their associates for the change in financial status that will occur upon their election to partnership. As a result, they can be distracted by financial concerns, and much of the goodwill generated by their elevation to partnership is lost. At the same time, those firms that prepare their associates for the change and lend a helping hand in the transition develop strong loyalties and better long-term partners.

Here are some of the topics the firm should put on the agenda well before the partnership elections.

Changing from Employee to Self-Employed Status

During his or her years as an associate of the firm, the new partner did not have to exercise much discipline in financial planning to be certain that at the end of the year all personal tax obligations were covered. As a common law employee, the firm was required to withhold income taxes from the associate's paycheck, so there were seldom any unpleasant surprises when tax time rolled around.

As a self-employed individual, the brand new partner will have to start thinking about taxes early in the year and make appropriate arrangements to set aside sufficient amounts from firm draws or distributions to meet income tax obligations. At least one lawyer I know found only one way to discipline himself in this regard. Each time he received a distribution as a new partner, he set aside 35% in a separate bank account that he called his tax account. He never wanted to consider those amounts his own, knowing that eventually he would have to pay them to the Internal Revenue Service. Another lawyer actually had her firm hold back a specified percentage of each draw to create a tax reserve available to her at tax time.

Estimated Tax Payments

Along with self-employment and taxes comes the obligation to file estimated taxes four times each year. Accordingly, the firm should encourage a new partner to review those quarterly payment obligations with his or her tax adviser, to avoid expensive tax penalties at the end of the year. Recognizing other financial obligations the new partner will face (see below), the first few months of partnership can present stressful cash flow issues, and coming up with what is basically one-quarter of the new partner's total estimated tax liability for the entire year can add significant pressure.

Doubling Up on FICA and the Medicare Hospital Tax

For most associates, their employer (the firm) had to match their FICA and Medicare hospital tax contributions as common law employees. In 2008, an associate earning an amount equal to the Social Security taxable wage base of $102,000 must contribute $6,324 in FICA and $1,479 in Medicare hospital taxes, which will be withheld from each paycheck. The associate's firm must pay a like amount directly to IRS. This same individual as a new partner must pay the amount formerly paid by the firm, thereby doubling required contributions to the Social Security system from $7,803 to a total of $15,606. This additional tax is mitigated a bit by the fact that the new partner can deduct one-half on his or her income tax return as a taxable or business expense.

Benefits

Most law firms today provide associates with a broad array of benefits, including health insurance, life insurance, and disability insurance. Due to favorable tax rules, these benefits generally can be provided tax-free. Even if the associate is required to contribute some share of these premiums, a '125 plan may allow the contribution to be made on a pre-tax basis. As an owner of the business, the new partner will be expected to pay for these formerly 'free' benefits and to do so on an after-tax basis. As a consequence, still another portion of firm distributions will not make it into the new partner's pocket.

Retirement Plans

Another expense that a new partner is not used to paying out of pocket is retirement plan contributions. As a self-employed owner of the firm, however, the new partner may be required to do so. If the plan is a simple 401(k) plan, perhaps the new partner can forego participation for the first few years of partnership to relieve the strain on cash flow, but some firm plans mandate participation by partners in order to satisfy requirements of the Internal Revenue Code. In those cases, the contribution obligation cannot be avoided.

Capital Contribution

Like any business enterprise, law firms require working capital to operate. They must buy furnishings and equipment and be certain they have adequate funds on hand to meet payroll and other obligations. Most firms therefore require that new partners 'buy in' to the firm, by contributing at least a proportionate share of the firm's needed working capital. This contribution can range from a modest amount to as much as $150,000 or more. With the other added expenses the new partner is facing, this is where the firm can be especially helpful to the new partner in one of several ways.

For example, some firms introduce their new partner to a 'friendly' bank (generally the institution that handles the firm's banking business) and arrange a loan from the bank to the new partner for the amount of the required capital contribution. This allows the new partner to pay in the required capital immediately, but to amortize the obligation over a number of years. It is not uncommon in these situations for the firm to guarantee the loan. Due to its connections with the bank, the firm also may be able to arrange for the loan to be made on more favorable terms than might otherwise be the case.

Alternatively, some firms effectively lend the required capital amount, by allowing the new partner to pay in the capital over a period of time, such as over three to five years, although under strict payment guidelines. One common approach is to provide for payment of the capital contribution through withholding of some percentage of the new partner's distributions, e.g., from 6% to 10%, until the full capital obligation has been paid to the firm. The percentage chosen should take into account the other calls on the new partner's distributions as well, such as amounts required monthly to pay for benefits and any mandatory retirement plan contributions.

Guaranteeing Firm Debt

While firms in a strong financial position can often avoid partner guarantees of the firm's line of credit or outstanding loans, that is not always the case. Accordingly, a new partner signing the firm agreement may well be asked to sign simultaneously a guarantee of the firm's obligations to its principal lender or its landlord. When asked to do so, the new partner should be certain to review any other loan covenants to which he or she is subject to make certain that signing a guarantee of the firm debt will not violate any covenant in another loan agreement. Almost always, partner guarantees are several but not joint, meaning that the new partner will be responsible only for that portion of the obligation to the bank that equals his or her proportionate share of ownership in the firm. New partners also should be reminded to disclose these guarantees on any loan application they file, for example, when seeking mortgage financing for a new home.

Conclusion

Becoming a partner of a law firm is often a lifelong goal of those entering the legal profession. It should be a celebrated occasion and not one that causes insecurity and financial distress. Understanding the impact of the financial burdens a new partner faces is important for both the firm and the new partner. Having in place a program to assist new partners through this transitional period can avoid the hard feelings and financial hardship that otherwise may result.

Michael E. Mooney is the managing partner of Nutter McClennen & Fish, LLP, in Boston.

So, you have given your associate the good news ' she has just been elected a partner of the firm. Congratulations. Now, it's time to talk about what this means for your new partner from a financial perspective, especially during his or her first few years as a partner.

Unfortunately, too many firms fail to prepare their associates for the change in financial status that will occur upon their election to partnership. As a result, they can be distracted by financial concerns, and much of the goodwill generated by their elevation to partnership is lost. At the same time, those firms that prepare their associates for the change and lend a helping hand in the transition develop strong loyalties and better long-term partners.

Here are some of the topics the firm should put on the agenda well before the partnership elections.

Changing from Employee to Self-Employed Status

During his or her years as an associate of the firm, the new partner did not have to exercise much discipline in financial planning to be certain that at the end of the year all personal tax obligations were covered. As a common law employee, the firm was required to withhold income taxes from the associate's paycheck, so there were seldom any unpleasant surprises when tax time rolled around.

As a self-employed individual, the brand new partner will have to start thinking about taxes early in the year and make appropriate arrangements to set aside sufficient amounts from firm draws or distributions to meet income tax obligations. At least one lawyer I know found only one way to discipline himself in this regard. Each time he received a distribution as a new partner, he set aside 35% in a separate bank account that he called his tax account. He never wanted to consider those amounts his own, knowing that eventually he would have to pay them to the Internal Revenue Service. Another lawyer actually had her firm hold back a specified percentage of each draw to create a tax reserve available to her at tax time.

Estimated Tax Payments

Along with self-employment and taxes comes the obligation to file estimated taxes four times each year. Accordingly, the firm should encourage a new partner to review those quarterly payment obligations with his or her tax adviser, to avoid expensive tax penalties at the end of the year. Recognizing other financial obligations the new partner will face (see below), the first few months of partnership can present stressful cash flow issues, and coming up with what is basically one-quarter of the new partner's total estimated tax liability for the entire year can add significant pressure.

Doubling Up on FICA and the Medicare Hospital Tax

For most associates, their employer (the firm) had to match their FICA and Medicare hospital tax contributions as common law employees. In 2008, an associate earning an amount equal to the Social Security taxable wage base of $102,000 must contribute $6,324 in FICA and $1,479 in Medicare hospital taxes, which will be withheld from each paycheck. The associate's firm must pay a like amount directly to IRS. This same individual as a new partner must pay the amount formerly paid by the firm, thereby doubling required contributions to the Social Security system from $7,803 to a total of $15,606. This additional tax is mitigated a bit by the fact that the new partner can deduct one-half on his or her income tax return as a taxable or business expense.

Benefits

Most law firms today provide associates with a broad array of benefits, including health insurance, life insurance, and disability insurance. Due to favorable tax rules, these benefits generally can be provided tax-free. Even if the associate is required to contribute some share of these premiums, a '125 plan may allow the contribution to be made on a pre-tax basis. As an owner of the business, the new partner will be expected to pay for these formerly 'free' benefits and to do so on an after-tax basis. As a consequence, still another portion of firm distributions will not make it into the new partner's pocket.

Retirement Plans

Another expense that a new partner is not used to paying out of pocket is retirement plan contributions. As a self-employed owner of the firm, however, the new partner may be required to do so. If the plan is a simple 401(k) plan, perhaps the new partner can forego participation for the first few years of partnership to relieve the strain on cash flow, but some firm plans mandate participation by partners in order to satisfy requirements of the Internal Revenue Code. In those cases, the contribution obligation cannot be avoided.

Capital Contribution

Like any business enterprise, law firms require working capital to operate. They must buy furnishings and equipment and be certain they have adequate funds on hand to meet payroll and other obligations. Most firms therefore require that new partners 'buy in' to the firm, by contributing at least a proportionate share of the firm's needed working capital. This contribution can range from a modest amount to as much as $150,000 or more. With the other added expenses the new partner is facing, this is where the firm can be especially helpful to the new partner in one of several ways.

For example, some firms introduce their new partner to a 'friendly' bank (generally the institution that handles the firm's banking business) and arrange a loan from the bank to the new partner for the amount of the required capital contribution. This allows the new partner to pay in the required capital immediately, but to amortize the obligation over a number of years. It is not uncommon in these situations for the firm to guarantee the loan. Due to its connections with the bank, the firm also may be able to arrange for the loan to be made on more favorable terms than might otherwise be the case.

Alternatively, some firms effectively lend the required capital amount, by allowing the new partner to pay in the capital over a period of time, such as over three to five years, although under strict payment guidelines. One common approach is to provide for payment of the capital contribution through withholding of some percentage of the new partner's distributions, e.g., from 6% to 10%, until the full capital obligation has been paid to the firm. The percentage chosen should take into account the other calls on the new partner's distributions as well, such as amounts required monthly to pay for benefits and any mandatory retirement plan contributions.

Guaranteeing Firm Debt

While firms in a strong financial position can often avoid partner guarantees of the firm's line of credit or outstanding loans, that is not always the case. Accordingly, a new partner signing the firm agreement may well be asked to sign simultaneously a guarantee of the firm's obligations to its principal lender or its landlord. When asked to do so, the new partner should be certain to review any other loan covenants to which he or she is subject to make certain that signing a guarantee of the firm debt will not violate any covenant in another loan agreement. Almost always, partner guarantees are several but not joint, meaning that the new partner will be responsible only for that portion of the obligation to the bank that equals his or her proportionate share of ownership in the firm. New partners also should be reminded to disclose these guarantees on any loan application they file, for example, when seeking mortgage financing for a new home.

Conclusion

Becoming a partner of a law firm is often a lifelong goal of those entering the legal profession. It should be a celebrated occasion and not one that causes insecurity and financial distress. Understanding the impact of the financial burdens a new partner faces is important for both the firm and the new partner. Having in place a program to assist new partners through this transitional period can avoid the hard feelings and financial hardship that otherwise may result.

Michael E. Mooney is the managing partner of Nutter McClennen & Fish, LLP, in Boston.