Madeline Jaszczak, CPA
12.06.2018 | Practice Made Perfect
Being asked to join the partnership of a firm is a measure of success as a legal professional. With that achievement comes tax and financial responsibilities that, surprisingly, few attorneys are fully prepared to deal with. These responsibilities include the unexpected individual federal and state and local tax filing and payment requirements, which can often be complex.
When taking this important career step, attorneys would benefit from addressing the following tax and financial questions prior to, or upon, becoming partner:
1. How will my income from the firm be taxed when I am a partner?
Most law firms operate as pass-through entities, which means that the income of the entity is taxed to the partners and not the firm. As such, each partner is responsible for reporting his or her share of firm income and paying applicable federal and state taxes.
Additionally, partners should be aware of the following:
Estimated Tax Payments: When an attorney becomes a full-equity partner, taxes must now be paid based on the Firm’s quarterly taxable earnings, which can be uneven throughout the year. For example, some law firms see lower profits in the first two quarters of the year and notably higher profits in the third and fourth quarters, resulting in uneven flow of annual taxable income to partners. Law firms generally provide their partners with data per quarter to calculate the varying estimated payments.
Full-equity partners who pay equal estimated payments throughout the year, without regard to their firm’s actual earnings, may be overpaying the IRS early in the year, and putting a strain on their own cash flow. Full-equity partners should consider, instead, annualizing quarterly estimated tax payments. Since earnings drive an individual’s cash distributions, partners should not make a larger payment than necessary in any quarter. The best practice, therefore, is to work closely with a tax advisor and the firm’s internal accountants to synchronize estimated payments to actual quarterly earnings. This requires the firm to release earnings data on a quarterly basis, which most firms do for the benefit of their partners.
For practitioners who do not wish to calculate annualized tax payments, there is the option of using the estimated tax safe harbor. The safe harbor allows individuals to make estimated tax payments to the IRS on a quarterly basis, based on 110% of that individual’s previous tax year liability. If current year earnings prove to be higher, the partner will only be required to pay the difference of tax due by April 15th of the following year, without normally applied penalties for underpayment. States have comparable annualization and safe harbor rules as well.
Deductions: Most partners are careful not to miss allowable deductions, but a common mistake law firm partners make is failing to deduct the interest paid on a capital account loan, which is money borrowed to make a capital contribution. Unlike itemized deductions, which are detailed on Schedule A of a tax return, the interest is deducted on Schedule E, to directly offset partnership income, including for self-employment tax purposes as well.
Business expenses for which firms will not reimburse partners for (such as certain cell phone expenses or business gifts up to $25 per person) may also qualify as Schedule E deductions.
Another significant deduction is health insurance premiums paid by a partner, including dental and an allowable portion of long-term care (depending on one’s age), known as the “Self-Employed (S/E) Health” deduction. S/E Health is deducted 100% on Page one of Form 1040, and not as an itemized medical deduction.
State Taxes: The potential exists for additional state tax return filings by partners of a law firm. If a firm has offices in multiple states, its partners will likely owe taxes at the state level in all states where the firm does business. Firm partners decide annually on the merits of filing under a composite return for all applicable states. Composite returns enable pass-through entities to compute and pay individual state income tax for all the nonresident partners. Although participating under a firm’s composite return facilitates administrative duties of filing taxes, electing into a composite return does not make sense in every case.
If a firm elects to file a composite return, partners need to decide whether it is appropriate to participate, or if it is more beneficial to file their own nonresident state returns. Partners also need to consider that filing composite returns may subject nonresident income to the highest marginal rate and not allow the taxpayer to take advantage of lower graduated rates. Such consideration is especially critical for a state with a high marginal tax rate, such as California (13.3% personal income tax top bracket) or New York (8.82%), and may even be higher when local levies are considered. Additionally, filing a composite return may prevent the taxpayer from taking advantage of deductions at the applicable state level or credits that he or she may otherwise have been able to use.
Whether being included in a composite return or filing a nonresident state return there is an offsetting credit to your resident state tax liability. This credit will reduce the amount of tax that you pay to your resident state. Whether you receive a full credit for the tax paid to a nonresident state will depend on the difference in the state tax rates. For example: A New York resident would not receive a full credit for tax paid to California. The credit is limited to New York’s tax rate which is less than California’s.
Self-Employment Taxes: In addition to the federal and state taxes to which partners are already subject, a partner’s share of firm income (now reported on a Form K-1 instead of a Form W-2) is also subject to self-employment taxes at a rate of 15.3%. The partners do receive an above the line deduction for 50% of the self-employment tax. This reduces their AGI and impacts the limitation of some itemized deductions, for example medical expenses and charitable contributions. Partners who make more than $200,000 ($250,000 if married, filing jointly) are also subject to the additional ACA Medicare Tax of 0.9%.
Retirement Plans – 401(k) and others: Qualified retirement plans – 401(k) Plans, Profit Sharing Plans, Defined Benefit Plans, among others – can provide benefits for both the partnership and the individual partners. For details on the various types of plans and how they work, see: Qualified Retirement Plans – A Primer for Business.
Moreover, if a firm does business overseas, and pays foreign taxes, partners may be subject to the U.S. tax rules and limitations for foreign tax credits.
2. What are the financial implications of becoming a partner?
Newly made partners will face significant changes in the financial aspects of their lives related to their new status as owners of a firm instead of employees. For example, as partners, they must pay the entire cost of benefits (e.g., 401(k), health insurance) in addition to quarterly estimated income and related taxes.
In addition, in most instances, an equity partner is required to make capital contributions to the firm. Some firms give new partners some time — two to three years — to pay the initial capital contribution and usually have the funds deducted from monthly draws or taken from year-end bonuses. Other firms provide capital loans for their partners.
New partners may also have to adjust to earning a monthly draw, with the bulk of earnings coming toward the end of the year. Monthly draw payouts may, potentially, be lower than that of a senior associate’s take-home pay, depending on the capital contribution requirements and the cash flow and profitability of the firm.
In short, it is critical not to wait to think about the various financial implications of partnership, including taxes and the options available for filing and payment. Begin as soon as possible. The key to avoiding common mistakes is finding an accountant who understands the nuances of the legal profession and is willing to work with new partners throughout the year to ensure that they are fully informed and are paying only the required amount of tax.
If you have any questions about the issues addressed in this article, please contact Madeline Jaszczak at 212.331.7662 | firstname.lastname@example.org, or John Fitzgerald at 212.331.7411 | email@example.com.
Berdon LLP, New York Accountants