Financial Planning for Equity Partners
Congratulations! If you’re an attorney at a prestigious law firm or a senior tax professional at one of the big four accounting firms, achieving equity partnership is the pinnacle you aimed for since passing the bar or the CPA exam. However, now you’re confronted with the challenge of financial planning for equity partners.
While reaching partnership status is a significant career milestone, it profoundly influences your financial prospects in both the immediate and distant future.
The positive aspect is that with increasing compensation, you gain the ability to accomplish two key objectives: elevate your lifestyle and diligently save for a time when you can reduce or completely step away from work. Or, as we call it at Brighton Jones, achieve Vocational Freedom.
To get there, you will need a solid plan in place.
What to expect as a partner
To begin, review your firm’s partnership agreement. This document provides clarity on essential aspects such as compensation, organizational structure, and management policies.
Understand what your firm offers its partners. Law firms typically have two primary partnership models: the single-tier and the two-tier systems. Most firms employ a two-tier partnership model, wherein a senior associate may advance to either a non-equity or full-equity partnership.
Non-equity partners receive a salary without acquiring ownership stakes in the firm, unlike their equity counterparts. This partnership structure is commonly utilized by firms to recognize the contributions of senior associates with a prestigious title while preserving the firm’s ownership interests.
The impact on your personal finances
Transitioning from a senior associate to a full equity partner brings substantial changes to a lawyer’s financial landscape. Here are five key considerations:
- You’ll need to invest capital into the firm as part of your partnership agreement.
- Your tax filing will become more intricate due to the partnership structure.
- While you’ll have to cover your own benefits expenses, the benefits package may be superior overall.
- As an owner of the law firm, you’ll experience both the advantages and risks associated with ownership.
- Your financial strategy should incorporate adjustments for increased cash flow and potential updates to your estate plan.
In light of these factors, if you’re advancing to a full equity partnership, it’s prudent to pose additional inquiries to gain a comprehensive understanding of your firm’s partnership dynamics:
- Is the firm structured as an LLC or an LLP? This impacts liability concerning debts and negligence by other members or partners.
- Will your compensation consist of a draw or a combination of draw and fixed pay?
- How is the draw amount determined for each partner, and at what frequency are draws distributed?
- What are the expected capital contributions, and when are they due?
- How will partnership status affect your benefits, and what will be the associated costs?
Capital contributions
Equity partnerships come with an obligation to purchase the partnership via a capital contribution to your firm. Depending on the firm, capital contributions generally range from 15 to 30 percent of the partner’s annual profits.
Most firms give new partners time to pay the initial capital contribution, ranging from 1-3 years. In most cases, firms have an existing banking relationship with terms to allow new partners to finance their contributions. A lump-sum contribution or deduction from your draws is also allowable in most cases.
Your firm’s partnership agreement will outline the terms of eligibility for repayment upon your departure from the firm.
Financial planning for equity partners and taxes
When you become an equity partner, you move from being a W-2 employee to a K-1 owner. As an owner, your firm does not withhold taxes on your income. You need to make sure that you allocate sufficient cash flow to cover quarterly tax payments. These estimated tax payments are straightforward and usually equal when you are a non-equity partner.
Paying estimated taxes based on the taxable earnings of the firm is something full equity partners must do. Your firm usually provides partners with all the data to calculate the payments. In this case, the payments should align with the firm’s earnings per quarter instead of being equal. Equity partners risk overpaying if they don’t collaborate with their tax professionals to synch these payments.
Equity partners must file taxes in all states where their firm operates, typically achieved through a state composite tax return. Opting out may be wise for high-tax states like New York and California. They can deduct interest paid on capital contribution loans and health insurance premiums, optimizing tax planning.
Retirement plans
Many law firms offer defined contribution and defined benefit plans to partners. These plans provide significant pre-tax retirement savings. For 2024, defined contribution plans allow partners to contribute up to $69,000 annually. If your firm offers a cash balance plan, your contribution can be well into the six figures.
Some firms match these plans with 401(k) plans. These plans are hybrids between a defined benefit plan and a defined contribution plan.
Holistic financial planning for equity partners
Current equity partners and soon-to-be equity partners usually do not have the time to deal with all the complications and moving pieces that go along with making the jump to ownership. It is vital that you align yourself with other professionals who can assist you in navigating these new waters.
Talking to a tax professional and a financial advisor is an excellent place to start.
