Accounting & Tax Tips
June 11, 2024

Tax Planning Tips for New Law Firm Partners to Maximize Your Earnings

Being promoted to partner at a law firm is an exciting and pivotal career milestone, but it also introduces a new spectrum of complex tax considerations.

Partnerships have unique tax reporting requirements and potential financial liabilities. Understanding these scenarios early can help you make informed decisions that safeguard your financial future. 

Every new law firm partner should evaluate the following tax and financial considerations:

1. Adjust Your Estimated Tax Payments to Reflect Cash Flow

Law firm incomes are notorious for their fluctuations year over year, which can result in variable tax payments. Many firms have uneven distribution schedules that are heavily weighted at the end of the year. Transitioning to an estimated payment schedule that aligns with your cash flow can ease financial stress. 

This template created by Wendroff & Associates allows you to input your quarterly earnings and calculate an estimated tax to pay the IRS and your state. Once you decide what you want to pay, you can submit your estimated taxes online with the IRS and most states. 

Since the IRS and most states require equal quarterly payments, consider using the annualized installment method if your income varies significantly throughout the year. This method adjusts payments based on income earned each quarter, helping to avoid underpayment penalties. For the IRS, use schedule AI of Form 2210 to calculate your estimated tax payments. You will use a similar form with your state tax return. 

We suggest working with a tax advisor and your firm’s accountant to sync your estimated payments to your actual quarterly earnings. 

2. Multijurisdictional Filings

One of the most surprising changes for new law firm partners is having to file and pay taxes in every state where the firm operates.

A common solution to managing filings across multiple states is opting for composite tax returns. This method consolidates filings and can eliminate the need to file separate state returns for every jurisdiction in which the firm does business. 

However, this approach is not universally beneficial. For example, in law firms that operate in states with high tax rates, such as California and New York, it often makes more financial sense for partners to file individual tax returns instead. The high rates in these states can lead to significant tax liabilities, and opting out of composite filings can result in material tax savings.

Potential reciprocal agreements between states further complicate the decision-making process. Such agreements might impact the decision on whether to file composite or individual state returns, especially for non-resident tax filings. These agreements could potentially offer more favorable tax conditions, making them a critical consideration in the tax planning process.

Another aspect of multijurisdictional filings is managing estimated withholding payments. Partners can choose to make these payments themselves or have the firm make them on their behalf. While having the firm manage these payments may reduce personal administrative burdens, it can also lead to overpayments and substantial refunds. This requires a careful evaluation of preferences regarding cash flow and the timing of tax payments.

A new development in 2021 was the Pass-Through Entity (PTE) tax election. This allows pass-through entities, such as S corporations and partnerships, to pay state income taxes at the entity level rather than at the individual level. In some cases, all your state taxes based on earnings from your law firm could be paid on your behalf for both nonresident states your firm works in and your resident state.

The purpose of this election was to be a workaround to the federal state and local tax (SALT) deduction cap implemented by the Tax Cuts and Jobs Act of 2017 and to allow you to apply state taxes paid as a deduction against your IRS partnership income. It’s important to be aware if your firm is paying PTE taxes on your behalf with your resident state so you don’t pay tax twice.

Navigating the complexities of multi-jurisdictional and PTE filings requires a strategic approach and, ideally, the guidance of a tax professional. The ultimate goal is to align tax filing strategies with individual financial situations and the unique tax landscapes of the states in which a law firm operates, ensuring optimal tax and cashflow outcomes for new partners.

3. Maximize Foreign Tax Credits

Partners in firms that operate internationally often face substantial tax payments to foreign countries. Multiple strategies can be used to minimize the impact of these foreign taxes on U.S. tax returns. 

The advantages of foreign tax deductions and foreign tax credits should be weighed carefully. Credits directly reduce your tax liability, while deductions lower your taxable income. Each option has distinct implications on the tax liability, and the overall benefit can vary greatly depending on individual circumstances. 

A tax advisor who understands these situations can provide tailored advice on whether a credit or a deduction would be more advantageous for reducing U.S. tax obligations. We can also determine if amending any prior year returns could further optimize tax outcomes, especially since a special 10-year look-back period may apply.

4. Avoid Last-Minute Tax Preparations

A proactive approach to tax preparation can prevent errors and ensure more efficient planning. By spreading out your tax-related discussions and decisions across the year, you can avoid the crunch and stress of tax deadlines. We always recommend at least one mid-year Strategic Tax Planning Session to review and optimize your financial situation.  

5. Retirement Plan Contributions

Contributing to your firm’s retirement plan and deferring income until later years may result in tens of thousands of dollars in tax savings. Maximizing your contributions can reduce your tax liability and enhance your retirement savings.

6. Tax Impact of Law Firm Milestones

Significant firm events, such as mergers, acquisitions, or transitions to another firm, can greatly affect your taxes. Preemptive planning with a tax advisor can help you navigate the complexities that accompany these changes.

Becoming a law firm partner means taking a holistic approach to your financial health. It’s important to ensure that your investment portfolio is managed with tax efficiency in mind and to consider the tax impact of every financial decision. Remember that the end goal is not just to increase what you earn but to maximize what you keep after taxes!

Use the Free Consult button below to discuss how our expert tax consultants can help you stay ahead of these considerations for a more secure and prosperous tenure as a law firm partner.

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