Attorney Partner Equity - What Is Attorney Partner Equity?
Accounting for partnerships is a process that takes time and effort. Depending on the partnership agreement, there can be a lot of adjustments to the partners' capital accounts. This article will discuss how to account for partner distributions, partner equity accounting, and non-contributing partners. Terminology and IRS rules will vary depending on the entity type of firm. See this article for a breakdown of the firm types.
What is attorney partner equity (APE)?
Attorney partner equity (APE) is a method used to calculate the value of each partner's interest in a law firm. Typically, there is a partnership agreement in place that defines the percentage of ownership per partner. Partner equity is also based on the number of years the partner has worked at the firm and the percentage of the profits generated by the firm during those years. APE, in its most simplistic method, is calculated as follows:
- Calculate the total annual profit of the firm.
- Divide the total annual profit by the years the partner worked at the firm.
- Multiply the result by 100. This will give you the percentage of the partnership profits attributable to the partner.
What is a partner contribution?
A partner's contribution to a limited liability partnership or limited liability corporation can be considered the same way as share capital in a company. It represents the ownership that each partner has in the business. The amount of capital each partner contributes can help to determine their level of control and decision-making power within the business. Attorneys that are partners can contribute not only cash but also assets and equipment can be considered a capital contribution. This contribution is considered a neutral transaction and is not a taxable event.
What is partner distribution?
As an attorney and business owner, you need to be paid. I often see solo firm owners who don’t pay themselves. You must be compensated for your work. When an attorney pays themselves, it becomes a distribution and should be coded as such in the chart of accounts. This is how you would structure the chart of accounts:
- Partner contribution
- Partner distribution
- Heath benefits
As depicted above, we even like to subcategorize a partner distribution account with health benefits or specific transactions that an attorney wants to track. At the end of the day, we roll that all up and provide these records to the tax professional for tax preparation.
Any withdrawal by the attorney that is not business-related should be coded to partner distribution. We also highly recommend that an attorney get a specific credit card to be used only for business items. That way, there’s no commingling, and it keeps the IRS very happy that these transactions are separated.
A partner distribution is NOT an expense on the books. This is a balance sheet transaction. Often, attorneys will ask, “where did all the money go?” when they view the profit and loss statement and balance that against the operating checking account balance. They forget that their withdrawals as distributions do not affect that bottom line as a deduction.
Additionally, the partner needs to consider that this money they take as compensation has NOT been taxed. The partners should be making estimated taxes to prevent a large tax bill at tax time and any penalties for not paying taxes in a timely fashion.
Second Company Strategy
Many attorneys will fund a personal S Corporation entity from the partnership distributions. When set up correctly, there is a separate FEIN, company name and QuickBooks file with payroll turned on. The attorney can then pay themselves a paycheck from this firm.
When is the distribution not a distribution?
The law firm payment to a partner at a firm that is an LLC with an S Corp election has to pay themselves a salary. We recommend that you get a payroll service like QuickBooks Online payroll or Gusto. Let them handle tracking your payroll taxes and paying them. Payroll tax compliance is a big deal, and you don’t want to have any issues paying the proper payroll taxes.
What should you pay yourself?
How much you can take out will depend on a few factors, like how much profit the firm made that year and how many partners there are. But generally speaking, a good guideline is you can usually take out up to 30% of the firm's profits as a distribution. Again, it is best to refer back to the partnership agreement when determining the best compensation for the firm's partners.
Attorney partners are typically compensated for their role in the firm in one of three ways:
- By taking a profit share, or
- By taking a draw, or
- By making an equity investment in the firm.
In many professional service firms, including law firms, accounting for partner payments is performed on a partner-by-partner basis. This means that even if all partners are compensated with the same payment type, each partner account is kept separately. A partner’s compensation must be broken down into parts to understand the accounting for partner payments.
It’s common for lawyers to question what their equity is worth, how they can collect it, and what they can contribute to the firm. I hope this article helps clarify equity accounting in a law firm and provides insight into the accounting of equity in the firm.
If you need guidance on how to make these entries, we are just a contact form away!