CLIFF NOTES -- 2012 Year-end Tax Planning for the Firm

Parsley Sage Rosemary & Ginsburg llp

“always a reasonable result for a reasonable fee, always”

MEMORANDUM

To:	Partners
From:	Mike Marget
Date:	December 11, 2012
Re:	Cliff Notes – 2012 Year-end Tax Planning for the Firm

           Year-end tax planning is a mindboggling concept in the best of times.  As the end of 2012 approaches, “uncertainty” is the operative word due to a combination of upcoming events, including the likely expiration of the 2001-era tax rates and a new Medicare tax levied on the high income earners.    

          I recently conducted a brief, informal and very unscientific survey of tax accountant friends who advise high income individuals, including a number of partners (shareholders) in law firms.  Their advice:  law firms should accelerate revenue and defer expenses this year in anticipation of higher tax rates in 2013.

1.  Why Accelerate Income and/or Defer Expenses?

          In most years, taxpayers prefer to defer revenue and accelerate expenses in order to minimize taxable income.  This year is different.  Absent agreement in Washington to the contrary, the highest marginal tax bracket automatically increases to 39.6% from the current 35% on January 1, 2013.  In addition, a new 0.9% Medicare contribution tax on earned income takes effect for 2013 for married taxpayers with modified adjusted gross income over $250,000 and over $200,000 for taxpayers filing single.  Taken together, the tax rate applicable to most law firm partners will increase by 5.5% on their law firm income earned next year.[i]

          With these likely 2013 rates, partners will owe 5.5% more in federal income tax on every dollar earned next year at the highest marginal rate as compared to the 2012 rates.  Accordingly, the partners will save $5,500 on every $100,000 of taxable income which can be “shifted” into 2012 from 2013. 

          Generally speaking, the idea of deferring income/accelerating expenses is a good idea when tax rates remain the same or are likely to decline year-to-year.  Conversely, if rates are likely to increase in the succeeding year (i.e., the likely 2012/2013 scenario), the opposite is true.  However, there are some caveats:

A.   Law firm compensation percentages are not static.  Partner A may be entitled to 30% of the profits for 2012.  Shifting $100,000 of income from 2013 to 2012 to take advantage of lower rates could result in a $5,000 windfall if Partner A’s profit percentage in 2013 falls from 30% to 25%. 

B.   For every action there is an opposite and equal income or not-income reaction for someone else.  Assume you pay your tax accountant every December for the advice and service provided during the year – including the suggestion this year to defer expenses in 2013 to maximize taxable 2012 taxable income.  If you decide to defer the accountant’s payment to January 2013, your law firm wins, and your CPA loses.  Because of your decision to defer the regular December payment to January, you have shifted taxable income from the lower rates of 2012 to the higher 2013 rates for your CPA.  Talk about being hoisted on your own petard!

C.   It is often difficult to “go back” in time.  Should your firm decide to defer associate and staff bonuses from December 2012 to January 2013, later reverting to a December bonus payday becomes problematic.  Switching back will mean 2 bonus payments in a single calendar year – one in January for the prior work year and a second in December for the concurrent work year.  Such moves should not be taken lightly since they impact issues raised in both A and B above.

D.   Not all partners are created equal from a tax perspective.  Whatever your firm decides to do – take your CPA’s advice and accelerate income/defer expenses for 2012 or simply maintain business as usual – discuss it with all the partners.  Don’t assume every partner has the same individual tax goals and will benefit from the same strategies.  Moreover, a dramatic income shift may subject certain partners to penalties and interest for underpayment of quarterly federal and state income tax estimates for 2012.

2.  Deferring 2012 Expenses to 2013

          The following is a partial list of things to consider if your firm wants to defer 2012 expenses into 2013:

A.   Vendor Payments.  Most law firms pay their vendors on a 30-day (possibly longer) payment schedule.  In prior years, your firm likely accelerated items scheduled for payment in early January in order to take the tax deduction in the current year.  If your firm decides to maximize 2012 taxable income, you will want to defer as many expense payments as possible.

B.   Year-end Bonuses.  If your firm typically pays bonuses to associates, staff and non-equity partners in December, you may want to consider postponing those payments to January 2013.  Be mindful, however, that the deferral of bonus payments may subject the receipients to higher tax liabilities at 2013 rates.

C.   Delay 4^th Quarter Nonresident State Composite Filing.  If your firm processes 4^th quarter composite filings in December (so partners can deduct the state income tax payments on their personal returns), deferring those filings and payments to January will shift the personal deduction from 2012 to 2013.

D.   Depreciation Elections.  Consider electing out of 50% bonus depreciation for qualifying assets placed in service in 2012 tax year. 

E.    Qualified Retirement Plan Contributions.  Generally, contributions to a qualified retirement plan for 2012 are deductible in 2012 if contributed in 2013 before the extended due date of the law firm’s tax return for 2012.  Firms wishing to maximize partner income for 2012 may want to consider taking a 2013 tax deduction for the 2012 plan year contributions, rather than electing to take the deduction for tax year 2012.

3.  Accelerating Income into 2012

          Law firms seeking to accelerate revenue can consider the following:

A.   Accelerate billable hours and progress bill clients for December time and soft costs and collect before December 31, 2012.

B.   Collect non-refundable retainer payments in December for work to be performed next year.

C.   Collect on outstanding accounts receivable, giving discounts were appropriate in order to save on the tax differential.

D.   Advise partners that they may want to consider converting their 401(k) account balances to Roth 401(k) balances before year-end – and pay the taxes this year at current rates as opposed to the then-prevailing rate applicable to future withdrawals.  (One nice feature of the Roth IRA conversion is it comes with a “reversal feature.”  If a taxpayer converts a regular IRA to a Roth IRA before year-end and it turns out to be a bad idea, the conversion carries with it a “re-characterization” feature.  Up until the due date of your tax return in 2013, you can reverse a Roth conversion.)

Conclusion

          Regardless of whether the President and Congress reach a compromise on “the fiscal cliff,” it is a safe bet that tax rates – for married taxpayers who earn over $250,000 ($200,000 if single) are going to be higher in 2013.  As a result, law firm managers should work with their outside accountants to make a plan and then involve the partners (and other stakeholders) in the 2012 year-end tax planning effort.  Doing nothing is a perfectly viable option – but only after all other alternatives are thoroughly explored and discussed.  Effectively, it may come down to something this simple – as to each thing which can be accelerated or deferred – should the partners pay the tax now or later?

OBLIGATORY DISCLAIMER:  This presentation was prepared for general guidance and discussion purposes and does not constitute professional advice.  Readers should not act upon the information contained herein without obtaining specific professional advice.  No representation or warranty (express or implied) is made as to completeness or accuracy of the matters discussed herein.

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[i] For purposes of this memo, I’m assuming all partners are in the highest marginal tax rate – currently 35%.

No 4th Quarter Lateral Hiring! (Subject to Exceptions)

Parsley Sage Rosemary & Ginsburg llp

“Always a reasonable result for a reasonable fee, always”

MEMORANDUM

To:	Management Committee
From:	Mike Marget
Date:	September 21, 2012
Re:	No 4th Quarter Lateral Hiring! (Subject to Exceptions)

There is never a bad time to add a lateral partner; especially someone with a big book of business, whose practice fits the firm’s culture, and who will be accretive to the financial bottom line.  However, certain times are better than others – early (in the fiscal year) is much, much better than later.

At a prior firm, we had a rule – no lateral hiring in the 4^th quarter.  Being a law firm, there were many exceptions to this rule.  One permitted filling vacancies when short-handed or when special expertise was needed for an active matter.  Another was crafted for the proverbial “lateral too good to” turndown; somebody certain to be snatched up by another firm if we don’t act immediately; the “let’s thank our lucky stars and ignore the calendar” candidate (“L2G2” for too good to…).

The rationale for the 4^th quarter lateral hiring freeze is simple arithmetic.  Assume the following:

a)     L2G2 joins New Law Firm (“NLF”) effective October 1, 2012, agreeing to the same 2012 compensation package as at Old Law Firm (“OLF”) – $300,000 annually: monthly draws of $15,000, plus deferred comp of $120,000 payable as a year-end distribution.

b)     L2G2’s October production at NLF is subpar due to transition issues – delays in transferring files, obtaining conflict waivers and the like.[i]

c)      The headhunter’s invoice (15%-to-20% of one year’s compensation) is paid before year-end.

d)     Invoices for October time are issued by mid-November, and then scheduled for payment on a 45-to-60-day cycle by L2G2’s clients.  November time is billed in December.  Little or no revenue is received in 2012 from L2G2’s clients or L2G2’s work on other firm clients. 

e)     In addition to making three monthly draw payments of $15,000, NLF must foot-the-bill for the entire $120,000 deferred comp for 2012 even though L2G2worked only three months at NLF.[ii]

 The negative financial impact to NLF’s legacy partners is fairly easy to calculate.  NLF will generate virtually no incremental cash-basis revenue to cover L2G2’s 2012 compensation and the recruitment fee.  As a result, NLF will have roughly $210,000 less net income available to distribute to legacy partners when it comes time to make the year-end distributions.[iii]  The $210,000 “loss” represents the investment NLF is making in L2G2.

	cost to NLF	paid by OLF	L2G2 total 2012 comp
NLF revenue from L2G2	$      --0--		
3 monthly draws	$       45,000		$     45,000
9 months draws		$    135,000	135,000
year-end distribution	120,000		120,000
recruitment fee (15%)	45,000
L2G2 2013 Compensation			$  300,000
total expenses	$    210,000	$  135,000
NLF Net Income (Loss)	$ (210,000)

Note:  The financial loss is greater if L2G2 joins NLF with a supporting cast (staff and/or other timekeepers) or if NLF incurs other incremental costs (e.g., higher insurance premiums).[iv]

With any lateral partner candidate – but especially those who must join the firm in the 4^th quarter – there are two questions to be answered after due diligence is completed and financial terms and projections made:

1.      Are the partners willing to relinquish current year compensation in exchange for projections of higher earnings in future periods?

2.      If the answer to the first question is “yes”, then how much current year compensation for what magnitude of return?

These two questions will be explored in future Management Committee Memos focused on:

• Creative accounting[v] for lateral partner investments, and 
• Financial due diligence/financial projections for potential lateral partners.

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[i] Lateral partners invariably assure me they will “hit the ground running;” their initial month’s billable hours will be exceptionally high; all client files will be transferred on Day 1.  It never happens that way. 

[ii] L2G2 worked 9 months of 2012 (January through September) at OLF, but forfeited the accumulated deferred comp by joining NLF.  In order to make up the difference to L2G2, NLF is on the hook for the entire $120,000.  The subject of Making a Lateral Partner “Whole” is discussed at length in a previous Management Committee Memo.

[iii] In an effort to reduce the 2012 “loss,” some law firms might structure L2G2’s compensation so the $120,000 make-whole payment is paid in 2013 against the 2013 budget, rather than as a 2012 payment.  L2G2 might be amenable to this structure – deferring taxable income on $120,000 for a year has some merit assuming tax rates are unlikely to increase.  However, I don’t think this is the best approach.  How to “cover” compensation “hit” to legacy partners will be covered in the promised future “creative accounting for investment in lateral partners” memo.

[iv] Despite the fact I really love footnotes, this is point is too important to bury in one.

[v] Creative lawyering is a good thing.  Creative accounting is a bad thing.  I sometimes find this troubling. 

Making a Lateral Partner "Whole" for Deferred Comp

Parsley Sage Rosemary & Ginsburg llp

“Always a reasonable result for a reasonable fee, always”

MEMORANDUM

To:	Management Committee
From:	Mike Marget
Date:	September 20, 2012
Re:	Making a Lateral Partner “Whole” – Year-end Distributions

Partners leave “money on the table” when they move from one firm to another. The money in question is deferred compensation – their share of profits for the year over-and-above monthly draws received – which is forfeited when they change firms before the year-end distributions are paid to partners by their Old Law Firm (“OLF”).  No worries though.  When this happens, lateral partners invariably look to New Law Firm (“NLF”) to “make them whole” with respect to the compensation left behind.

The term “year-end distributions” references payments to partners in Year 2 relating to their respective share of the firm’s net income earned in Year 1.  These payments are typically made several weeks or even months after year-end.[i] 

If your law firm intends to hire lateral partners, the earlier in the year you can accomplish this, the better.  “Earlier” means less expense in terms of NLF “make-whole” payments to lateral partners.

If your firm is going to lose partners to lateral hiring, “later” is better.  The longer OLF can hold onto them means (a) more billable hours generating more profits in the current year and (b) departing partners will forfeit more deferred comp which can be used to additionally compensate those who remain at OLF.  Although this incremental money is inconsequential in the long run, short-term it is better than a poke-in-the-eye.  Plus, if the departures can be delayed from say February 28 to April 30, OLF enjoys the knowledge that the poaching firm (NLF) is on the hook for larger make-whole payments, as explained below.

Fact Pattern 1)     “Partner” expects to earn $300,000 from the profits of OLF. 2)     The $300,000 will be paid in the form of 12 monthly draws of $15,000 each ($180,000) and $120,000 in the form of a year-end distribution. 3)     Accordingly, each month Partner is working and “earning” $25,000, of which $15,000 is paid currently and $10,000 is deferred. 4)     The deferred comp earned at OLF does not vest until actually paid, meaning Partner will be reluctant to make a lateral move unless indemnified for all the deferred comp. 5)     OLF (like most firms) pays the year-end distributions days/weeks/months after December 31 and has a partnership agreement provision requiring 30-days notice of withdrawal.

Most law firm’s take their time before paying year-end distributions.  Some time is needed to “close the books” and calculate net income for the year.  Additional time may be required at those firms where the amount of each partner’s year-end distribution must be decided by a compensation review process.  Year-end compensation decisions are time intensive.

Such delays are inevitable, but there also are practical benefits to those law firms who engineer a significant gap between December 31 (year-end) and the later payment date of the year-end distributions.  One such benefit is reduced interest expense.  During the gap period, the firm can utilize the accumulated cash for working capital purposes, postponing the inevitable borrowing from bank lines-of-credit once the year-end distributions are funded. 

Another collateral benefit accrues to those law firms who defer paying the year-end distributions the longest.  Each month of delay means:

A.     For OLF – more money left on the table which will be used to increase compensation for everyone else; and
B.     For NLF – more money must be allocated from its budget to make-whole the lateral partner with respect to the deferred comp left behind at OLF.

A Tale of Two Laterals

There are two law firms.  Let’s call them G&J and JLY.[ii]
·        G&J pays its year-end distributions by January 31. 
·        JLY delays the year-end distributions until the end of March.

As a result, at G&J partners who plan to leave make their intentions known during the first week of February – as soon as the year-end distribution checks clear the bank.  That “whooshing” noise you hear at midnight on February 28^th – after the standard 30-day notice period expires – is the revolving door as partners move out of firms like G&J who pay their year-end distributions in January.

The timing is different at JLY.  New partners tend to join JLY laterally earlier in the year, but because JLY delays these distributions until the end of March, JLY partner defections typically commence on April 30.

Assume NLF makes offers to two lateral partners – one from G&J; the other from JLY.  Both earned $300,000 for 2012 (pursuant to the terms set forth in the Fact Pattern box) and agree to accept the same terms from NLF for 2013.  Keeping these lateral partners pari passu with their 2012 compensation package obligates NLF to pay each of them the entire deferred comp amount for the year.  Without this deferred comp indemnity, partners would require some significant other motivation to change firms.

The former G&J partner is able to join NLF on February 28, 2013, after collecting $30,000 from 2 monthly draws from G&J and forfeiting 2 month’s deferred comp ($20,000).  In order to “annualize” the former G&J’s 2013 compensation at $300,000, NLF will pay $270,000 for 10-months’ work – 10 monthly draws of $15,000; plus $120,000 in deferred comp for the year.  ($100,000 of the deferred comp amount accrued while the former G&J partner worked at NLF; $20,000 represents a “make whole” payment for the deferred comp earned but forfeited at G&J.)  In essence, the former G&J partner is costing NLF $27,000 a month for the 10-months’ work in 2013.

lateral from G&J	monthly	2013	paid by G&J	paid by NLF
# months worked	1	12	2	10
monthly draws	$      15,000	$   180,000	$      30,000	$   150,000
deferred comp	10,000	120,000	-	100,000
"make whole" pymt	-	-	-	20,000
Total	$      25,000	$   300,000	$      30,000	$   270,000
compensation per month		$      25,000	$      15,000	$      27,000

Meanwhile, the former JLY partner is not available to join NLF until May 1, 2013.  The former JLY partner collected 4 monthly draws totaling $60,000 at JLY and forfeited 4 months’ deferred compensation upon joining NLF.  As a result, to annualize the former JLY partner at $300,000 for 2013, NLF will pay this lateral partner $240,000 for 8-months’ work – 8 monthly draws of $15,000 and the entire $120,000 deferred comp for the year. 

lateral from JLY	monthly	2013	paid by JLY	paid by NLF
# months worked	1	12	4	8
monthly draws	$      15,000	$   180,000	$      60,000	$   120,000
deferred comp	10,000	120,000	-	80,000
"make whole" pymt	-	-	-	40,000
total	$      25,000	$   300,000	$      60,000	$   240,000
compensation per month		$      25,000	$      15,000	$      30,000

Because G&J pays its year-end distributions at the end of January, the make-whole payment by NLF to the former G&J lateral partner is $20,000 and the average monthly compensation for this lateral is $27,000 per month over 10 months. [iii] 

 
The former JLY requires a make-whole payment of $40,000 simply due to how JLY manipulates its year-end distribution funding which delays lateral movement 2 months longer than firms like G&J.  As a result, NLF pays the former JLY lateral partner $30,000 a month over the 8 months of the transition year.

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[i] Granted there are firms who pay year-end distribution on or about December 31 each year.  Law firms taxed as corporations pay their bonuses before year-end to avoid double taxation on profits.  There are a few partnerships who similarly like to make these payments between Christmas and New Year’s.  Nevertheless, even in these situations partners rarely announce their intentions to depart until after these payments are made.  So, considering partnership “notice” provisions, delays due to notifying clients and simple good manners, there is usually a 30-day transition period (if not more) between year-end and a lateral move.  That 30-day period represents one month of deferred compensation for the current year which will be “left on the table” when the partner leaves.

[ii] These are real firms and the year-end distribution dates are factual.

[iii] This is $2,000 more monthly than what it cost G&J (see, in the Fact Pattern narrative).  Assuming the former G&L partner receives no increase the following year, the monthly cost to NLF in 2014 reverts back to $25,000 a month.  (Aren’t numbers fun?)