The Cost of Making Partner

Cotterman says that firms often take steps to ensure that their young partners are “whole,” even after capital contributions and the additional cost of benefits and taxes. A&FP contributor William Cobb of Houston's Cobb Consulting agrees: “They really don't want a new partner to be making less than a senior associate in take-home pay.”

Even so, associates on the partnership track — who are probably still paying off student loans — need to prepare for the potentially higher expenses that come with being a new partner. Partners often warn associates to get ready for a tough first couple of years, Cotterman says. “I jokingly say that last year's bonus as a senior associate — hold onto that. No fancy trips,” he says.

But associates are often much more focused on what they need to do to become partner than on what it will cost them once they get there. “There is so much literature and discussion on what it takes to become a partner. It's not so much the logical cost in terms of financial cost, but how to treat your cases, how to deal with existing partners … how to build your own book of business,” says Liam Duffy, who is chair of the law practice committee of the American Bar Association Young Lawyers Division.

Duffy, an associate at Rosen, Rosen & Hagood in Charleston, SC, says younger lawyers probably aren't as cognizant of the financial costs. “I don't find myself thinking enough about those issues,” he says.

Lisa Smith, a principal at Fairfax Associates, a consulting firm in Washington, DC, says that firms do not typically share information about capital contributions, for instance, with associates until they have been at the firm for a few years. “I don't think in the hiring process that firms would be talking about that,” she says. The entire subject of partnership costs can be touchy. Leaders at a number of firms around the country declined requests to be interviewed for this article.

No matter how tight-lipped their firm, associates who think they have a strong shot at making partner should start planning for its costs.

According to Cotterman, capital contributions generally range from 15% to 30% of a partner's annual profits, while Smith says the capital accounts can be as high as 30% to 40%.

“They get all of it back when they leave unless the firm dissolves and it's not there to give them,” Smith says, noting that it's often paid back within five years after a lawyer's departure.

Partners in Am Law 100 firms could be asked to contribute up to $400,000 in capital, with partners at Am Law 200 firms putting in around $200,000, says Jeff Grossman, managing director for the Legal Specialty Group at Wells Fargo Wealth management in Charlotte, NC.

Typically, Cotterman says, a young partner is responsible for a “base” buy-in that's collected over a couple of years, but the lawyer will need to add to that capital contribution in the future as the lawyer's ownership percentage and income increases.

Cotterman says that capital contributions are a practical way for firms to acquire working capital to do business and grow. They also encourage partners to value their ownership in the firm — a positive thing in Cotterman's view. “I'm a strong believer that if you make someone pay for something, they tend to take better care of it than if it was given to them,” he says. Firms take different approaches for obtaining the capital from newly minted partners. Cotterman says that most firms give new partners some time — say, two to three years — to pay the initial capital contribution and usually have the money deducted from monthly draws, or taken from year-end bonuses.

Other firms arrange for loans through a bank. With the bank financing method, Smith says, the debt is the individual partner's debt, but it is secured by the accounts receivable of the firm. Some firms use a third approach, an annual cash call based on the needs of the firm as determined by its leaders, she says.

Some firms don't require capital contributions simply to avoid the complications of having to return the capital if a partner retires or leaves the firm, says Cobb. Those firms instead maintain a line of credit for working capital, and retain some earnings so the firm can afford to bring in new partners and allow new partners to take two or three years to get their business up to speed.

Chris Hanslik, chairman of 28-lawyer BoyarMiller of Houston, says his firm asks partners to contribute $25,000 in capital, and allows new partners to pay it over two full years. To make it easier for new partners, an associate promoted to partner at the end of 2017 would not have to make the first capital payment until the end of 2018, when he or she would write the firm a check out of their year-end bonus. The firm also gives lateral partners two years to make the capital contribution, Hanslik says.

“Our philosophy is, if we need your money in order to have a successful business, we are doing something wrong to run our business,” he says. Tax issues can be thorny for new partners, too. An associate who becomes a partner is reclassified from an employee, who receives a W-2 income tax form, to an owner, who receives a K-1 tax form. Taxes can be much more difficult to prepare, and associates should consider hiring an accountant, says Eric Lawrence, a tax partner in Gelman, Rosenberg & Freedman, of Bethesda, MD, who does a lot of tax work for law firms and firm partners.

“The tax laws are very complicated when you are a nonemployee, because you need to make quarterly estimated tax payments. The forms themselves are very complicated,” Lawrence says. He says that partners will be required to pay the full cost of benefits such as medical insurance and pension contributions, which will be a deduction on tax forms, he says.

New partners also may need to adjust to earning a monthly draw, with the bulk of their pay coming toward the end of the year. That monthly payout may be less than their former senior associate take-home pay, depending on their capital contribution and the cash flow and profitability of their firm, Grossman says.

Beyond the financial changes, Cotterman suggests that an additional cost for new partners is psychological. New partners may think they are finally on a “new train” that takes them to a new set of destinations and provides them with tempting opportunities to reward themselves — a new house, a second house, a fancy car or luxurious vacations.

These lawyers would be better served, he says, to consult a financial planner to not just understand what it means to be self-employed, but also to think through their personal financial priorities.

“There is some pressure for young partners to live the lifestyle of a partner,” he says — and that can be costly, too.

*****
Brenda Sapino Jeffreys is a Senior Reporter for The Texas Lawyer, an ALM sibling publication of Accounting and Financial Planning for Law Firms.

Making partner isn't cheap, and the cost is more than just the years of hard work and stress that associates put in as they reach for the brass ring.

Newly minted partners face real financial expenses as they change their job title. Some of those costs are related to their new status as owners of the firm instead of employees: Now they must pay the entire cost of benefits and quarterly estimated income taxes. There's also the capital contribution required by many firms, which represents the so-called “skin in the game” that each equity partner puts up to help run the firm and finance its work.

Because of those costs, it's possible — although unlikely — that newly promoted partners will take home less than they did as a senior associate, says James Cotterman, a principal in Altman Weil and a member of our Board of Editors who advises firms on compensation and capital structure.

Cotterman says that firms often take steps to ensure that their young partners are “whole,” even after capital contributions and the additional cost of benefits and taxes. A&FP contributor William Cobb of Houston's Cobb Consulting agrees: “They really don't want a new partner to be making less than a senior associate in take-home pay.”

Even so, associates on the partnership track — who are probably still paying off student loans — need to prepare for the potentially higher expenses that come with being a new partner. Partners often warn associates to get ready for a tough first couple of years, Cotterman says. “I jokingly say that last year's bonus as a senior associate — hold onto that. No fancy trips,” he says.

But associates are often much more focused on what they need to do to become partner than on what it will cost them once they get there. “There is so much literature and discussion on what it takes to become a partner. It's not so much the logical cost in terms of financial cost, but how to treat your cases, how to deal with existing partners … how to build your own book of business,” says Liam Duffy, who is chair of the law practice committee of the American Bar Association Young Lawyers Division.

Duffy, an associate at Rosen, Rosen & Hagood in Charleston, SC, says younger lawyers probably aren't as cognizant of the financial costs. “I don't find myself thinking enough about those issues,” he says.

Lisa Smith, a principal at Fairfax Associates, a consulting firm in Washington, DC, says that firms do not typically share information about capital contributions, for instance, with associates until they have been at the firm for a few years. “I don't think in the hiring process that firms would be talking about that,” she says. The entire subject of partnership costs can be touchy. Leaders at a number of firms around the country declined requests to be interviewed for this article.

No matter how tight-lipped their firm, associates who think they have a strong shot at making partner should start planning for its costs.

According to Cotterman, capital contributions generally range from 15% to 30% of a partner's annual profits, while Smith says the capital accounts can be as high as 30% to 40%.

“They get all of it back when they leave unless the firm dissolves and it's not there to give them,” Smith says, noting that it's often paid back within five years after a lawyer's departure.

Partners in Am Law 100 firms could be asked to contribute up to $400,000 in capital, with partners at Am Law 200 firms putting in around $200,000, says Jeff Grossman, managing director for the Legal Specialty Group at Wells Fargo Wealth management in Charlotte, NC.

Typically, Cotterman says, a young partner is responsible for a “base” buy-in that's collected over a couple of years, but the lawyer will need to add to that capital contribution in the future as the lawyer's ownership percentage and income increases.

Cotterman says that capital contributions are a practical way for firms to acquire working capital to do business and grow. They also encourage partners to value their ownership in the firm — a positive thing in Cotterman's view. “I'm a strong believer that if you make someone pay for something, they tend to take better care of it than if it was given to them,” he says. Firms take different approaches for obtaining the capital from newly minted partners. Cotterman says that most firms give new partners some time — say, two to three years — to pay the initial capital contribution and usually have the money deducted from monthly draws, or taken from year-end bonuses.

Other firms arrange for loans through a bank. With the bank financing method, Smith says, the debt is the individual partner's debt, but it is secured by the accounts receivable of the firm. Some firms use a third approach, an annual cash call based on the needs of the firm as determined by its leaders, she says.

Some firms don't require capital contributions simply to avoid the complications of having to return the capital if a partner retires or leaves the firm, says Cobb. Those firms instead maintain a line of credit for working capital, and retain some earnings so the firm can afford to bring in new partners and allow new partners to take two or three years to get their business up to speed.

Chris Hanslik, chairman of 28-lawyer BoyarMiller of Houston, says his firm asks partners to contribute $25,000 in capital, and allows new partners to pay it over two full years. To make it easier for new partners, an associate promoted to partner at the end of 2017 would not have to make the first capital payment until the end of 2018, when he or she would write the firm a check out of their year-end bonus. The firm also gives lateral partners two years to make the capital contribution, Hanslik says.

“Our philosophy is, if we need your money in order to have a successful business, we are doing something wrong to run our business,” he says. Tax issues can be thorny for new partners, too. An associate who becomes a partner is reclassified from an employee, who receives a W-2 income tax form, to an owner, who receives a K-1 tax form. Taxes can be much more difficult to prepare, and associates should consider hiring an accountant, says Eric Lawrence, a tax partner in Gelman, Rosenberg & Freedman, of Bethesda, MD, who does a lot of tax work for law firms and firm partners.

“The tax laws are very complicated when you are a nonemployee, because you need to make quarterly estimated tax payments. The forms themselves are very complicated,” Lawrence says. He says that partners will be required to pay the full cost of benefits such as medical insurance and pension contributions, which will be a deduction on tax forms, he says.

New partners also may need to adjust to earning a monthly draw, with the bulk of their pay coming toward the end of the year. That monthly payout may be less than their former senior associate take-home pay, depending on their capital contribution and the cash flow and profitability of their firm, Grossman says.

Beyond the financial changes, Cotterman suggests that an additional cost for new partners is psychological. New partners may think they are finally on a “new train” that takes them to a new set of destinations and provides them with tempting opportunities to reward themselves — a new house, a second house, a fancy car or luxurious vacations.

These lawyers would be better served, he says, to consult a financial planner to not just understand what it means to be self-employed, but also to think through their personal financial priorities.

“There is some pressure for young partners to live the lifestyle of a partner,” he says — and that can be costly, too.

*****
Brenda Sapino Jeffreys is a Senior Reporter for The Texas Lawyer, an ALM sibling publication of Accounting and Financial Planning for Law Firms.