Attorneys at the largest, most selective law firms work in a rarefied space. They serve leading companies, advise top officials, and walk hallowed hallways alongside the nation’s elite. And a select few may eventually become partners – both a professional and financial triumph that promises status and other rewards.
Years of creating complex financial plans for legal professionals has highlighted that the transition to partner can be financially difficult. While making partner can seem to be the key to financial success, in the short-term many new partners are not prepared for the transition to partner – grabbing the golden key may require paying in capital, a transition from being taxed as a W2 employee to a K1 owner, a complex set of financial expectations and benefits, additional obligations and requests, not to mention liability and significant compliance limitations.
Law firms rarely prepare rising partners beforehand for fear of somehow promising them a partnership they may not ultimately earn. And while the financial rewards of partnership will certainly be extensive, the transition and first year can be complex, and cash flow difficult.
In our experience, rising partners and senior associates can prepare for the transition and avoid pitfalls that may unnecessarily hinder their finances during this transition by taking the following into consideration. Note that the “income partner” tier at some firms can provide a gentler glide-path to the jump to true ownership at the “equity partner” level – here we are talking about equity partnership when we refer to a “partner.”
Understanding the Landscape
The cultures of law firms vary widely. So does each firm’s approach to partnership. Some law firms can be paternalistic, laying out specific expectations and surrounding their partners with various benefits and support systems. Others are more hands off, with attorneys fending for themselves.
One of the big differences among firms is the financial process of becoming partner. Some firms require up-front cash for paid-in capital, while others may subtract an attorney’s partnership stake from earnings over time. It can come as a surprise to have to “pay in” to become partner.
First year partners face other cash demands like transitioning to making quarterly estimated payments (as they move from W-2 employees to K-1 owners), as well as expectations that they contribute to firm sponsorships or other charitable requests. Some firms will facilitate cash flow in the first year and beyond, offering pre-approved credit with little if any underwriting through the firm’s primary banking relationships. Whether taking advantage of this type of financing is a good idea is another matter.
A New Way of Getting Paid…and Taxed
How partners are paid, and taxed, is sometimes a shock to young partners, especially in the first year. As a partner, one’s overall compensation will be driven not only by one’s own productivity, but also by the earnings of the firm. Plus, taxes are owed on all company earnings, even those amounts that go toward a capital commitment that a junior partner may never see. These not insignificant quarterly estimated payments need to be made, but in the first year, junior partners haven’t participated in any prior year-end distribution of earnings – money that the other partners are able to set aside for taxes and other cash requirements. So, many new partners must scramble to find the cash to pay their estimates. This can be exacerbated if in the year or two prior to becoming partner a rising senior associate uses savings or bonus windfalls to pay down law school debt or put a deposit down on a home, leaving little cash on hand.
Law firms may also provide specialized benefits as part of a pay package that should be carefully evaluated. For example, most will provide group life or disability insurance coverage. While group coverage can mean lower premiums on average, new partners who are younger and healthy may be able to secure this coverage at an even lower cost on their own.
Don’t Put Away Your Checkbook
Newly minted partners also face other demands on their cash. Charitable and sponsorship requests are not paid at the company level but by the partners themselves at most law firms. It’s hard to say no when a senior partner or client asks a young attorney to support an event or donate to a pet cause. In addition, there are often co-investment opportunities offered to law firm partners including venture or private equity investment funds that, while potentially lucrative in the future, require a cash commitment now.
Making matters worse, it isn’t uncommon for new partners to experience “lifestyle creep,” a pressure to keep up with other partners by living in select neighborhoods and vacationing at exclusive spots. Cash flow eventually gets better and partners will most likely be able to afford more lifestyle demands, but a partner’s own individual preparation and planning will determine when.
Other Things to Keep in Mind
Newer partners facing a cash crunch rarely think about a time when they may need to transfer wealth, but eventually, successful partners will grow into their earnings and should set up the appropriate structures. Techniques including gifting and specialized trusts aren’t unique to lawyers but are recognized best practices for high earners.
Lawyers also face some unique compliance constraints by virtue of their profession, making it important to avoid conflicts of interest. That means it is critical that attorneys only use financial advisors with full discretion over their accounts. Some will need to get firm approval to set up an account and copy the firm on any transactions, creating a paper trail. They may need their advisor to avoid trading in certain securities, and some attorneys may even be required to set up blind accounts.
It goes without saying that becoming a partner means becoming an owner. New partners should understand that they are now potentially liable for the firm’s operating decisions. While rare, law firms can overextend themselves and be forced into bankruptcy. For example, after overextending its payments for leases and retirement benefits, New York-based Dewy Ballantine’s partners found themselves targeted in the firm’s bankruptcy case (even those who had departed the firm before the bankruptcy).
Here are a few tips for new partners hoping to ease the first-year transition:
- Senior associates on track to become a partner should talk to a financial advisor in advance. An advisor will create a short-term plan to identify cash needs and avoid common missteps in the year or two leading up to becoming partner. They can also evaluate the various benefits offered to partners. Once through the cash flow hump, an advisor can also help set up a longer-term financial and estate plan appropriate for an attorney’s future finances.
- Consider using an investment account as collateral for margin borrowing or a line of credit. This credit is a relatively low-cost way to tap needed cash in the first year. New partners should think carefully before taking advantage of the convenient financing firms may offer as part of a transition to partner. The cost for these unsecured credit programs may be significantly higher than a secured line arranged privately through an advisor.
- Recognize the value in delegating financial decisions. Lawyers are accustomed to giving advice and are generally good at taking it. Most find their time limited and are often willing to assign the management of their financial affairs to experts they trust because they have similar relationships with their own clients. Selecting an advisor who understands the constraints a partner may face – both cash flow and compliance-wise – is critical.
