Partner Compensation Estimations: A Crucial Step in Year-End Planning for Law Firms
Year-End Financial Tips for Law Firms: Part 3
Estimating partner compensation accurately is an essential part of year-end planning for law firms. This process isn’t just about determining pay — it directly impacts the firm’s tax planning, financial stability, and each partner’s financial health. A thorough approach to partner compensation estimations can also help align the firm’s financial outcomes with partner expectations, supporting morale and retention.
Barto Consulting’s third installment in our series on year-end financial tips for law firms emphasizes the importance of accurate partner compensation estimations because they are crucial to a successful year-end plan.
Partner compensation systems are at the heart of any law firm’s success and range in structure and complexity. Some are as simple as splitting the firm’s distributable income by fixed percentages while others have many tiers or layers of calculations. Regardless of complexity, there are certain characteristics that all systems must have to be effective. Among those, clarity is paramount. Partners and those managing the compensation plan need to have a bead on potential compensation ranges throughout the year. While analyzing this information that should start at the beginning of the year, especially when paying out draws and distributions throughout the year, the last couple of months of the year is when partner compensation should be predictable within a very manageable range.
For law firm managers, projecting these amounts accurately can be challenging, as partner compensation entails working with both financial and statistical (hours, billings, originations, etc.) information that may vary drastically as the year comes to close.
Why Accurate Partner Compensation Projections are Essential
- Law Firm Finances: Compensation estimation affects the firm’s liquidity and ability to reinvest in growth. Inaccurate estimates could lead to cash shortfalls, making it difficult for the firm to meet financial obligations or achieve budgetary goals. Accurate partner compensation estimations help ensure that the firm has the resources it needs to maintain operations and plan for investments.
- Individual Partner Impacts: For partners, compensation stability and predictability are key to personal financial planning. Any shortfall in projected compensation can disrupt cash flow and undermine financial goals. Additionally, partners’ perception of compensation fairness directly affects morale and retention; when estimates fluctuate drastically it can sometimes disrupt the perceived fairness and equity of the compensation structure.
- Tax Implications: Partner compensation directly impacts each partner’s tax burden, as they pay taxes on their allocated share of the firm’s profits. Over- or underestimating a partner’s compensation can lead to unexpected tax liabilities or missed tax planning opportunities, creating stress and financial strain at tax time. In our current tax environment, partners have more decisions to make at the end of the year than in years past and the answers, which vary depending on each partners’ individual income levels, could save many thousands of dollars in tax. Here are some of the relevant factors.
- Qualified Business Income Deduction – This deduction, while not available to all lawyers, could impact quite a few law firm partners making large sums of money. A simplified description is that this is a deduction equal to 20% of each partner’s Schedule K-1 income. If the partner is married and has taxable income on his or her tax return of less than $383,900, there is a good chance this deduction would apply. If taxable income is higher than that, the benefit quickly diminishes. To put this in perspective, a partner making $600,000 or $700,000 could easily qualify for this deduction, with proper planning, especially when considering the availability of the following two deductions.
- Pass Through Entity Tax Programs (PTET) – These are programs that exist in many states that, if applied properly, make individual state income tax payments tax deductible (otherwise, they are limited to $10,000 on your personal return). Taxpayers elect in and make payments through the law firm to realize the benefits. Law firm partners can choose to make these payments in December of any given year to lower their taxable income for a certain year. From year to year, as a partner’s expected marginal tax rate changes, this is a valuable tax planning tool to push and pull income into different years.
- Pension Contributions – Pension contributions are an amazing tool to reduce taxable income. In many plans in 2024, partners can make deductible pension contributions up to $69,000, and for those firms that have defined benefit plans, certain partners may be able to increase the deductible contribution to exceed $300,000 annually. For such a high amount, pension plan documents need to be in place by the end of the year. So, knowing the amount of K-1 income that will be coming from the law firm is incredibly valuable in making these decisions.
Tips for Accurately Estimating Partner Compensation
- Use Accurate Financial Projections: Estimating compensation should be rooted in the firm’s projected income and cash flow. Regularly update these forecasts to ensure compensation estimates reflect the law firm’s current financial situation. Accurate projections also allow partners to understand the revenue dynamics influencing their compensation.
- Implement Cutoff Dates and Measurement Periods: Set a clear cutoff date for tracking metrics that determine compensation. This period may end slightly before the fiscal year to allow for final adjustments, creating a buffer that ensures partners have time to review and understand their compensation projections without last-minute surprises.
- Align with Advisors: Partner compensation should be considered alongside tax planning. Be in close communication with your firm’s CPAs to ensure the implications of year-end decisions and fluctuations are fully understood. Your pension plan third-party administrator (TPA) should also be in the picture to advise on required or potential pension contributions that will be available to the firm and/or its partners that are working on their year-end tax planning.
- Document Assumptions and Adjustments: Clearly document any assumptions or adjustments made during the compensation estimation process. Transparency in these decisions helps prevent misunderstandings and ensures all partners are on the same page, reducing potential conflicts. Nothing ever goes exactly to plan, but knowing and communicating the pertinent assumptions and their impacts on partners and the year-end plan is key.
Accurate partner compensation estimation is more than just numbers — it’s a strategic approach to law firm stability, partner satisfaction, and financial health. By focusing on reliable projections, clear cutoff periods, and tailored tax strategies, law firms can ensure that year-end compensation reflects fair value for each partner’s contributions and sets the firm up for a successful new year.
Barto Consulting helps law firms navigate the complexities of year-end partner compensation estimations and planning. With expertise in financial forecasting, tax strategy, and tailored compensation structures, we provide the insights needed to make accurate, fair, and tax-efficient compensation decisions. If you have questions about year-end financial planning at your law firm, email Derek so he can help you get your law firm off to a great financial start in the new year.
Previously in this Series
