Financial planning for a law firm partner requires specific expertise and an understanding of the complexities that arise throughout a partner’s life cycle. One of the most significant events in this cycle is promotion to partner. The changes involved go far beyond the compensation component and affect nearly every aspect of your financial life, from cash flow and tax changes to investments and capital account funding, long-term retirement planning, insurance, and trust and estate planning. While all law firms are structured differently to some degree, they tend to share similarities in their benefits, tax, and retirement plan programs, many of which are unique to the law firm world. Familiarity with the general structure of these programs allows an advisor to provide specific and relevant advice and guidance to clients across the law firm universe.

Cash Flow and Tax Planning

One of the most significant changes that occurs upon promotion to partner is the shift from a W-2 employee to a K-1 partnership method of taxation. Coupled with the income recognition nature of law firms, this can often lead to high quarterly estimated tax payments due, without the corresponding cash flow to fund them. While many firms will make some type of cash distribution to partners at or near the time of the quarterly estimated payment, these payments are often insufficient to fully fund the tax liability. In the early years of partner status, when considerable wealth has not yet been accumulated in the portfolio, this can often lead to a need for short-term borrowing or potentially selling portfolio assets (sometimes at a taxable gain) to fund cash flow. This has become especially relevant in recent years due to the decision by many law firms to take advantage of the pass-through entity tax election (PTET). By making this election, state taxes are due now, while the partner does not take a corresponding federal deduction until a later date.

Working with the partner’s accountant and formulating a proactive plan to address these cash flow needs can be imperative, especially in the early years. On the plus side, the bulk of a partner’s annual after-tax savings are typically distributed in a lump sum during the first quarter of each calendar year, allowing for a methodical approach to portfolio rebalancing and an opportunity to confirm that long-term planning goals are being met (or a reevaluation of why they are not).

Investment Planning

Many law firms have an extensive and ever-changing list of public securities/investments that partners are not allowed to buy or sell because the firm may have confidential non-public information about them. It can be challenging for a partner to create a comprehensive investment plan around those restrictions. In addition, many law firms offer their partners various private investment opportunities, usually extended by the firm’s clients. These are typically illiquid vehicles with varying risk profiles and long-term investment horizons. Advisors must be prepared to analyze and offer insight not only into specific investment opportunities, but also the impact they would have on the client’s overall asset allocation and liquidity. Another consideration that impacts investment decisions is the tax regime under which law firm partners fall, especially in light of many law firms’ expansion overseas. For example, the UK’s offshore fund regime can create significant negative tax consequences for partners who are US taxpayers residing in the UK. Wherever possible, investment in US-registered funds (not passive foreign investment companies) that comply with US and UK regulations is recommended.

Firm Capital Account

At most law firms, partners may be required to maintain a capital account at the firm that is used for ongoing business operations, to tide over periods of low revenue or billing delays, and most importantly, to satisfy creditors should the firm find itself in financial trouble. This is a real risk, as demonstrated by the collapse of Dewey & LeBouef in 2012, the largest law firm failure in history.

The amount and structure of the required capital contribution will vary by law firm, but the initial contribution, even if prorated over several years, can be a considerable amount for a new partner. It is important to understand the various funding and financing options available for both initial and ongoing contributions. Most large firms have a banking relationship that offers attractive financing terms. The interest paid on these loans is deductible from the company’s income, making them more attractive than other potential sources of financing, such as home equity loans, even in today’s higher interest rate environment.

Capital account balances should also be considered in the context of retirement planning, as these balances can often exceed $1 million or more at retirement and can represent a significant source of liquidity and a balance sheet item in the immediate post-retirement period. Importantly, in most cases, capital account funds are after-tax dollars, making them more attractive than savings for post-retirement retirement plans.

Retirement/Pension Plans 

Many firms offer partners the ability to participate in a number of qualified retirement plans, as well as non-qualified pension plans that are not widely seen outside the industry. Regardless of the type of plan, partners will be able to make significantly higher contributions than the traditional 401(k) plan limit they are accustomed to. One such plan that has become more popular in firms is the cash balance pension plan. Participation in these cash balance plans (a type of qualified defined benefit plan) requires an irrevocable election for mandatory annual contributions to an additional tax-deferred account, where funds are pooled and managed at the firm level rather than segregated at the partner level. Many firms also offer unfunded non-qualified pension plan structures that can be specifically designed by the firm with unique rules or structures. It is helpful to know the specific details of each firm’s plan, which are often provided in the firm’s partnership agreement. Many include a “cap” on the amounts that can be paid based on company revenues or significant cuts for early retirement. Therefore, familiarity with the company’s benefits department and plan structure is critical for financial, retirement and insurance planning.

Insurance

Most law firms require each partner to maintain a certain minimum amount of life and disability insurance coverage. When considered as an income replacement mechanism, these amounts are often inadequate based on typical law firm partner compensation and the many years of potential future earnings at risk. This typically means obtaining additional coverage through a tiered term life insurance structure that decreases as the partner accumulates his or her after-tax savings, along with purchasing additional long-term disability coverage in the private market. A separate life insurance analysis will often be necessary as a partner approaches retirement, as while the balance sheet has typically grown sufficiently to self-insure in line with the maturity of term policies, the need to make a pension decision between individual life insurance or joint and survivor payments is often required. An analysis should be performed on a per-partner basis to decide between a survivorship election or an individual life insurance election coupled with life insurance to determine the optimal economic outcome.

Trust & Estate Planning

The time to become partner often coincides with a review (or in many cases, initial drafting) of a client’s estate plan. In years past, many of the larger law firms provided this service free to partners or at a reduced cost using in-house trust and estate staff. Many firms have reduced their in-house estate planning departments, resulting in an increased role for the financial advisor in planning, structuring, and eventual implementation of these estate planning goals. It is important to not only design a plan that will accomplish these goals, but also one that is flexible enough to accommodate any balance sheet changes and future estate tax regulations.

Using a revocable trust in conjunction with a partial distribution will ensures that the estate is distributed according to the client’s dispositive intent without disrupting administration. Incorporating the option for a surviving spouse to disclaim assets to a spousal and/or credit shelter trust can provide additional flexibility, regardless of the estate tax rules in effect at the time of death. For those partners who have significant net worth, utilizing the lifetime gift tax exemption (currently $13.61 million per person) by making gifts to irrevocable trusts may be appropriate given the uncertainty of this exemption amount after current law ceases to apply after 2025. Certain trusts, such as the spousal lifetime access trust (“SLAT”), can accomplish this goal while still providing flexibility through continued family access to funds.

Our advisors at Cerity Partners have extensive experience working with partners at the world’s largest law firms. We have developed a deep understanding of the complex and unique issues that impact partners throughout their careers, and can provide every stage of the planning process from initial formulation through execution.