Nonequity Partners are facing financial problems at law firms

The rapid expansion of non-equity partners within law firms often results in an undesirable consequence for lawyers: significant health and tax costs that are not matched by the significant profit distributions that full partners receive. Many leading law firms classify non-equity attorneys as full partners for tax purposes, subjecting them to Medicare, Social Security, and Healthcare-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-lawyer law clients is only slightly higher than that of his associates. He noted: “The increase in total compensation due to the increase in salary and bonus potential is being wiped out.” These financial implications have prompted law firms and their staffs to reevaluate their structures, especially as more firms establish non-equity tiers to attract and retain talent while increasing profitability. 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, according to data from American Lawyer.

Adjustments and adjustments

Some non-equity partners receive additional compensation to recognize their expenses, while others advocate for their companies to change their tax classification because of these costs. Additionally, some partners are adapting to this change, valuing the title of “partner” and recognizing the potential for other tax deductions. Sheppard, Mullin, Richter & Hampton have launched a partnership college to help lawyers adjust to their new tax status. “We ensure that we limit any risks,” said Luca Salvi, chairman of the company’s executive committee. “It requires adjustment because 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 minted lawyers join a firm as associates, they are considered employees for tax purposes and receive W-2 forms from the Internal Revenue Service. After being promoted to non-equity partners, many are classified as self-employed and receive IRS K-1 schedules, similar to full partners.

K-1 filers are responsible for the entirety of their Social Security and Medicare taxes, while employers cover half of these expenses for W-2 employees. Scruggs noted that the K-1 filers he advises bear 100% of their health insurance premiums, while companies typically subsidize 20% to 50% of these costs for W-2 employees. In addition to Sheppard Mullin, firms that have used K-1s for non-equity partners include Kirkland & Ellis, Shearman & Sterling, Duane Morris, Thompson Hine and McDermott Will & Emery, as evidenced by public records and filings. insights from current and former partners at 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, argues that K-1s have led to lower revenues due to higher tax liabilities. Former Thompson Hine partner Rebecca Brazzano described the title of non-equity partner as “a meaningless title that is more like an albatross.” Both companies chose not to comment. Duane Morris has indicated that she “strongly” disagrees with the allegations, while Thompson Hine has stated that she does not engage in public comment.

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

“Income partners represent one of our most important assets,” he noted. 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-equity partners last year to soften the financial impact of K-1 forms.

In addition, Shearman & Sterling also used K-1 forms for its non-equity partners, as reported by a former partner of the firm who wished to remain anonymous. Both Kirkland and Shearman & Sterling chose not to comment.

Tax ambiguity and financial implications

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

Large law firms, which are substantial entities – 95% of the top 100 firms generated more than $500 million in revenue last year – can realize millions in annual savings by categorizing employees into K-1 rather than W-2. In 2024, Noyes indicated that companies could realize a 7.65% savings in Social Security and Medicare taxes for K-1 partners on their initial salary of $168,600, along with a 1.45% reduction on income above that threshold. For a firm with approximately 140 non-equity partners, these savings could exceed $2 million. In addition to higher tax liabilities, growing non-equity partners face significant costs due to the need to fully cover their own health care costs.

For a high-deductible family plan, this could add an additional $14,400 annually, as noted by Scruggs. Still, 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 for non-equity partners in the early years, noted Rebecca Stidham, partner and team leader for the law firm services group at consultancy Withum. “A survey of first-year partners would show that many feel like they are breaking even or are at a disadvantage,” she says.

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

Nevertheless, it is crucial for lawyers to ensure that the promotion is financially beneficial, emphasizes consultant Derek Barto. “The move from W-2 to K-1 requires more than just a 10% salary increase to be worthwhile.”

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