It is difficult to manage a successful practice while balancing family obligations and maintaining focus on your financial plan. As a partner of a law firm, you are an owner of the business which presents a unique set of financial challenges as well as opportunities. With proper planning, you can generate significant savings and, ultimately, build wealth at a much faster rate.
Cash Flow. Because most law partners cannot accurately predict their earnings in any year, it is critical to maintain cash-based investments to withstand periods of fluctuating or reduced income. The need to maintain short-term reserves can impede your ability to systematically save for retirement, children’s educations, and other financial goals.
Taxes. As an equity partner in a law firm, income is reported on a Form K-1 (instead of a W-2) and is subject to self-employment taxes of 15.3% on the first $132,900 of net income plus an additional 2.9% on the net income over $132,900. Some taxpayers may be required to pay an additional Medicare tax of 0.9% if their income is above a certain limit based on their filing status ($250,000 for joint filers and $200,000 for single). These limits are for 2019 and subject to change annually. Since taxes are not withheld from distributions, you are required to make estimated tax payments; and because law firms do not distribute profits evenly throughout the year, you may need to make estimated payments of varying amounts throughout the year. Coordinating these payments with a tax professional can help avoid potentially substantial under/late payment penalties.
The increase in mergers and acquisitions coupled with states’ increased focus on capturing tax revenue means more partners working in firms in multiple states, which may require partners to file returns in multiple states. Partners should work closely with their tax advisor to determine whether filing individual state returns versus a composite state return will minimize their tax liability.
Retirement Plans. In addition to traditional profit sharing plans, many law firms offer defined benefit plans and non-qualified deferred compensation plans. In 2019, most law firm partners are eligible to contribute up to $56,000 ($62,000 for individuals age 50 and over) to their firm’s qualified plans. If your firm offers a cash balance plan, it is possible for your eligible contribution to be in excess of $100,000. Typically, every dollar contributed is tax deductible so the after-tax cost can be as low as 50% of the total contribution. A firm’s retirement plan is likely the most effective tax shelter available. Maximizing the benefits of your retirement plans requires coordination of income tax, investments, cash flow, and estate planning. It is important to consider the financial planning and tax tradeoffs; the most successful balance of assets includes a mix of both retirement and after-tax assets for optimal flexibility in retirement.
Estate Planning. For established law partners who have contributed significant sums to their firms’ retirement plans, their plan balances may account for a significant portion of their net worth. Younger partners with minor children must also take care when naming beneficiaries. Retirement plan beneficiaries are too often an afterthought or overlooked all together and a mistake here can unravel your estate plan.
There are no one-size answers to the above, however, with careful planning you can maximize your firms’ benefits, reduce your tax liability, and reduce your stress on cash flow.