The rapid expansion of non-equity partners within law firms often results in an undesirable consequence for lawyers: substantial health and tax expenses that do not accompany the significant profit distributions that full partners receive. Many prominent law firms classify non-equity attorneys as full partners for tax purposes, subjecting them to Medicare, Social Security, and health-related taxes that associates do not face.

As a result of these additional financial burdens, financial planner Eric Scruggs noted that the net income of his non-equity attorney clients is only slightly higher than that of associates. He commented: “The increase in total compensation due to the increase in salary and bonus potential fades.” These financial implications have led law firms and their staff to re-evaluate their structures, particularly as more firms establish non-equity tiers to attract and retain talent while improving profitability. According to data from American Lawyer, nearly half of partners at the 200 largest law firms by revenue were classified as non-equity partners last year, up from 40% in 2013.

Source: The American Lawyer

Adjustments and adaptations

Some non-equity partners receive additional compensation to recognize their expenses, while others advocate that their companies change their tax classification because of these costs. Additionally, some partners adapt to this change, appreciating the title of “partner” and recognizing the potential for other tax deductions. Sheppard, Mullin, Richter & Hampton has established a “partner university” to help lawyers acclimate to their new tax status. “We make sure to mitigate the risks,” said Luca Salvi, president of the company’s executive committee. “It requires adjustment as it represents a different way of life. I experienced a similar shock when I became a partner.”

The transition from associate to partner

When newly graduated attorneys join firms as associates, they are considered employees for tax purposes and receive W-2 forms from the Internal Revenue Service. Upon promotion to non-equity partners, many are classified as self-employed and receive K-1 programs from the IRS, similar to full partners.

K-1 taxpayers are responsible for all of their Social Security and Medicare taxes, while employers cover half of these expenses for W-2 employees. Scruggs noted that the K-1 taxpayers he advises bear 100% of their health insurance premiums, while companies typically subsidize between 20% and 50% of these costs for W-2 employees. In addition to Sheppard Mullin, firms that have used K-1 for non-equity partners, or have done so previously, include Kirkland & Ellis, Shearman & Sterling, Duane Morris, Thompson Hine and McDermott Will & Emery, as records indicate public and opinions of current and former partners of these companies.

However, not all non-equity partners are satisfied with their K-1 status. Duane Morris and Thompson Hine are currently facing legal challenges. Meagan Garland, a non-equity partner at Duane Morris, says K-1s have led to reduced profits due to increased tax liabilities. Rebecca Brazzano, former non-equity partner at Thompson Hine, described the title of non-equity partner as “a meaningless title more like an albatross.” Both firms have chosen not to comment. Duane Morris has expressed that he “totally” disagrees with the allegations, while Thompson Hine has stated that he does not make public comments.

McDermott Will & Emery stopped issuing K-1 forms to its non-equity partners, known as income partners, in 2020, moving to W-2 forms, according to firm president Ira Coleman. “We consulted with our revenue partners and revenue partner committee, and they expressed the need for a more efficient approach,” Coleman said. “Navigating the complexities of filing in multiple states and managing extensive administrative responsibilities may not be ideal.” Although the company faced certain costs, Coleman emphasized that the investment was justified.

“Revenue partners represent one of our most important assets,” he said. Kirkland & Ellis, a pioneer in establishing the non-equity partner category, continues to issue K-1 forms for non-equity partners, as indicated by two former partners and one current partner who requested anonymity regarding tax classification. According to a former partner, the firm increased compensation for non-share partners last year to mitigate the financial implications associated with K-1 forms.

Additionally, Shearman & Sterling also used K-1 forms for its non-equity partners, according to a former partner at the firm who wished to remain anonymous. Both Kirkland and Shearman & Sterling chose not to comment.

Tax ambiguity and financial implications

The ambiguity of the Internal Revenue Code allows law firms to provide “guaranteed income” to non-equity partners while designating them as 0% shareholders, according to Corey Noyes, founder of Balanced Capital, a tax consulting firm for tax professionals. right.

Large law firms, which are substantial entities (95% of the top 100 firms generated more than $500 million in revenue last year) can achieve annual savings in the millions by classifying employees as K-1 instead of W-2. In 2024, Noyes indicated that companies could realize a 7.65% savings on Social Security and Medicare taxes for K-1 partners on their starting salary of $168,600, along with a 1.45% reduction in revenue that exceed that threshold. For a company with approximately 140 non-equity partners, these savings could exceed $2 million. In addition to increased tax liabilities, growing non-equity partners face significant costs due to the need to fully cover their own healthcare expenses.

For a high-deductible family plan, this could work out to an additional $14,400 a year, as Scruggs noted. However, self-employment insurance deductions for a partner with a 35% marginal tax rate could alleviate about $10,000 each year, he added. The timing of compensation can pose challenges during the early years for non-equity partners, said Rebecca Stidham, partner and team leader in the law firm services group at advisory firm Withum. “A survey of first-year members would reveal that many feel they are either balanced or at a disadvantage,” he said.

However, K-1 attorneys have the advantage of deducting unreimbursed business expenses from their tax obligations, as highlighted by Ronald Shechtman, outgoing managing partner of the New York-based firm Pryor Cashman. “With the shift to remote work, there are numerous deductible expenses available,” he noted.

However, it is essential for lawyers to ensure that the promotion is financially beneficial, highlighted consultant Derek Barto. “The transition from W-2 to K-1 requires more than a 10% pay increase to make it worthwhile.”

The financial challenges of non-equity partners in law firms.