Next week taxes are due for all law firms, since most firms are partnerships, these taxes are individually owed by the partners in the firm based on their share of the firm’s net income from 2011. With a soft economy there might be a big temptation to get creative in firm accounting to help boost 2011 net income.
Here are some considerations:
- Most law firms operate on a modified cash basis for accounting and there are almost no standards for “how modified” from a pure
cash accounting method this accounting becomes. One key element, especially in larger firms that requires the use modified cash accounting is the payment in advance for litigation expenses on behalf of a client, these are deemed to be a loan to the clients because they are assumed to be recoverable, regardless of the outcome of the case.
- Taxes are calculated on a share of net income, not necessarily cash distributed. Therefore one consideration for partners is the
payment of income tax without corresponding cash distributions. Therefore, partner paid in capital for the year is subject to tax, however there is no cash, in effect to cover it. Many partnerships do not distribute 100% of net income and instead reserve cash for partner capital accounts to help fund on-going investments and future pension needs.
- Most firms have bank lines of credit, this always a tricky situation as year-end approaches. The issue becomes, how muchof the cash from the line will be used to help fund year end distributions. A risky situation is when firms substantially draw into their bank lines to fund partner distributions. If firms choose to take this route how far into the following year does it take to zero out the line?
- Some firms will look to “capitalize” expenses instead of outright expensing them in the tax year. For example, fees for lateral hire recruiting expenses. By capitalizing these over say 3 years the firm takes a much lower expenses on the Income Statement and the net income looks much better. Keep in mind that this can come back to bit a firm in that there is no cash for this “improved income” since the bill for the recruiting fee is obviously paid.
- Firms may be tempted to do “extraordinary” things in December to prop-up net income. For example, delay paying expenses that are normally due or “early booking” client advance retainer payments prior to work being done. Again, since there are few standards for law firm accounting these might appear to be attractive options.
- Many law firms have outside auditors that more help protect the partners against liability claims than really perform audits.
These auditors may actually just do reviews and not audits. The issue again is, to what standards will the auditors compare the firms practices.
- Some firms are more concerned with the annual reporting of Profits Per Equity Partner, than the actual cash health of the firm. This can be a risky ego trip when the PPEP look attractive but the firm has no cash.