You made it through law school, you passed the bar exam and now you are an attorney. You were lucky enough to have had help through scholarships or from family to pay for school, and you may still have student loans to pay off. You are a grinder in big law, working tirelessly as an associate, driving to make partner. You didn’t plan for your career to turn into a sales position on top of all the technical skills you developed over the years. You may be presented with the opportunity to become a partner soon. When you get the offer, you will want to be financially prepared.
Becoming a law firm partner is an opportunity to become an equity owner of the firm packed with financial complexity. You compensation will change from W2 salaried associate to K1 partnership distributions. You will typically need to buy into the firm requiring capital or loans to purchase units. Your tax return will likely show more income than ever, however you may be left wondering where it all went. Some firms may offer an income partner as a glide path to jump to true ownership as an equity partner. Either way, you will need to be ready and we have some notes to help you prepare.
This hypothetical example will walk you through a common process of becoming a partner. You are an associate; your W2 salary was $250,000 last year. Your spouse earns $100,000. Your take-home pay, excluding your spouse, is around $150,000 after your tax withholding, 401(k) max deferral and other benefits are withheld. You are paid every two weeks and your paychecks are a consistent $5,770 and allow you to manage bills in a simple manner. Midway through the year, you are offered to become a partner. Your spouse and you spouse celebrate!
Each law firm partnership unit is $50,000 and you are offered four units; you’re excited, but you realize you only have $150,000 in cash reserves. You decide you will put $50,000 toward the units and finance the other three units. The law firm has a relationship with a big bank that offers LIBOR (London interbank offering rate currently 5.4%) plus 1%. The loan will be an eight-year term, four years of interest only payments with the last four amortized with principal and interest. Each unit compensated partners $90,000 income last year, and the firm had a great year.
The following year your W2 income has ended, and now you are on K1 income draws. Your first draw is in the month of February, and the statement shows a gross distribution of $5,000, but the net after the health plan was only about $3,000. What gives? You thought you’d be making $400,000 this year, it’s February, and your cash flow is way less than you expect with the increase in compensation. Welcome to partnership pay. The law firm has paid out all of last year’s earnings. The firm starts from scratch again in the new year as they receive billed hours and settlements. Early in the year, the firm must ensure it can cover operating expenses before they can make K1 distributions to the partners.
Midway through the year, the K1’s start kicking up. In August a $35,000 K1 distribution comes in, and September a $30,000 distribution. As the year goes on bigger K1 distributions come in. When all is said and done around February the following year the last K1 comes through as the firm calculates year end totals. You did receive gross K1 distributions of $400,000. $20,500 came out for 401(k), $23,000 came out for medical, defined benefit plan contributions were $27,600, you maxed out the HSA for $7,300, other benefits came out to $16,000, loan interest and payment were $24,000 and estimated and state tax came out to $122,000 leaving you with $150,000. No one told you that your net income might be the same despite earning much more money. We see new partners feel broke because they do not understand what to expect with the new compensation structure and the liability of paying for share units.
You ended up netting the same? How could this be? Young attorneys don’t factor in all the costs and expenses of becoming a partner. The toughest part of all is the uneven cash flow you receive. Small payments come in during the first half of the year, and you may also owe income tax from the previous year due in April. You must prepare for this by building up a bigger cash reserve and living beneath your means until you can gain control of your cash flow. Talk to current firm partners to better understand your expected monthly cash flow or contact us and we can walk you through it.
If you think you will make partner plan early so you can more comfortably pay for it. Plan to save extra cash reserves so you can purchase share units ahead of time so you can minimize loan needs. If units are valued at $50,000 plan to have at least half of the units you will buy saved in advance. If partners are awarded four units at a time, target $100,000 in a separate saving account to pay for half.
To handle the cash flow change, seek to keep at least one year of living expenses in cash. If you spend $150,000 in living expenses, that should be enough to sustain cash flow through the first half of the year. In the example I gave, from February to July, payments might be $35,000 of the $400,000 expected income, the biggest payments tend to be the last ones of the fiscal year. So January or February might have a payment of 25% of the total income for the previous year. The first year you are partner, expect a slow start to the year before the bigger payments come in. In the previous example, you might have living expenses of $75,000 from the first half of the year and owe another $25,000 in taxes from the previous year. In that example, you’d dip down to $85,000 before the big K1’s kick in. You will be in great financial shape if you can get over the first-year adjustments and not fall behind on taxes or debt obligations.
In conclusion, you need to be financially prepared for the changes that come from being a W2 salaried employee to be a K1 law firm partner with a lot more financial obligation. Expect your income to increase and your cash flow to be complex. Build up an emergency fund of one year of expenses and a partnership units savings account. Work with a financial planner that has experience in working with law firm partners.