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An Accountant's View: Financial Trends that Affect Law Firms

January 2008

With the approach of tax season, law firm administrators are eager to understand how the latest developments will affect their firms as financial deadlines draw near. These developments can be structural, like choice of entity, or strategic, like the use of key performance indicators. Either way, they are essential to a law firm's bottom line.

This subject was discussed by a panel of accounting experts at a core-competency session of the Mile High Chapter of the Association of Legal Administrators (www.milehighala.org), held Nov. 14 at the Adams Mark Hotel in Denver.

Speakers were Paul Egan, Lori Gibson, Sean McBride and Shawn Windle – all CPAs with Denver-based accounting firm Ehrhardt Keefe Steiner & Hottman, PC.

Choice of entity

Many older and more established law firms were formed as professional service C corporations.  Many firms formed over the past 25 years were created as partnerships.  Most of the law firms being launched today are being formed as limited liability companies.

“A C corporation is a taxpayer, separate and distinct from its shareholders,” said Egan.  “Taxes can effectively be avoided by ‘zeroing out’ corporate income – paying professionals enough compensation to leave little or no taxable income.”

Many law firms were formed as PSCs in order to take advantage of retirement plans that could be used to shelter income.  Today, this advantage no longer exists.  However, because of the one-time tax costs incurred by making the switch to another entity, most existing PSCs have opted to remain as such.  “For most firms,” said Egan, “to switch would be a tax disaster.”

S corporations, partnerships and LLCs are all “pass through” entities.  The entity itself is not subject to tax; instead, its income and losses flow out to its shareholders or members – who include their share of the income on their own tax return or use their share of the losses to offset other income.

S corporations, LLPs and LLCs allocate income to owners on Schedule K-1.  Separately stated items include interest income, dividend income, gains and losses on sale of assets, rental income or loss, charitable contributions and guaranteed payments to partners.  What is left over is “ordinary income.”

Other tax concerns

Other areas to watch closely at tax time are charitable contributions, meal and entertainment deductions, and sales and use tax.

“In a C corporation, charitable contributions are limited to ten percent of taxable income, with a five-year carryover,” said Egan.  “When combined with the need to ‘zero out’ taxable income each year, administrators can avoid a tax trap by paying a bonus to shareholders, which shareholders can use to make individual charitable contributions.  These are valuable deductions.  Use them, don’t lose them.”

When individual lawyers file LLP/LLC tax returns, their charitable contributions are limited to 50 percent of adjusted gross income, also with a five-year carryover.

When it comes to meals and entertainment, 50 to 100 percent of certain expenses are non-deductible.  However, the full amount can be deducted when:

  1. The value is stated on an invoice and billed to a client;
  2. The value is included in the income of the employee or independent contractor;
  3. The expense is for an internal meeting meal, or for meals and other expenses incurred for recreational, social or similar activities primarily for the benefit of employees; or
  4. The expenses are too small to reasonably be accounted for.

Finally, as public jurisdictions try to maximize their revenue sources, many law firms are being audited on sales and use taxes.

“When it comes to sales and use tax, you really have to know the law and look closely at every invoice,” said Egan.  “Materials prepared for distribution at a live seminar are not taxable, but those prepared for distribution via mail or the Internet are taxable.  UPS or postage is not taxable, but shipping and handing is.  Original court reporter transcriptions are not taxable, but copies are.  If you aren’t sure, ask for help.”

Financial planning

In the area of financial planning, law firms should attend closely to issues raised by cash-basis accounting, client trust accounts and funds advanced as part of client costs.

Most law firms operate on a cash-basis accounting system – which records financial events based on cash flows and cash position.  “Lawyers like to be able to look at income statements and see what their actual distribution will be,” said Gibson.

The advantages of cash-basis accounting are that a firm does not have to pay income tax on outstanding invoices until the cash actually arrives.  Plus, it is possible to bring the books to “zero sum” at the end of the year merely by paying more or less of the outstanding payable and distributing bonuses to partners.

“On the negative side, a firm might not recognize losses as fast,” said Gibson.  “Because revenues and expenses are not matched, financial statements can be way off if a firm is growing or shrinking dramatically.  If 100 percent of net income has been distributed, this may create the need for a capital call – never a popular option.”

Gibson also encouraged law firms to pay careful attention to the trust accounts used for funds held by an attorney for the benefit of a client.

“A lot of money flows through some of these accounts,” said Gibson. “Often, they are not as clean as they should be.  Jan. 1, 2008, changes to the rules of professional conduct will tighten requirements as well as enforcement.  For example, a partner rather than an employee will now be liable for reconciliation in these accounts.”

In an audit, the IRS will be looking in particular for accounts where the case has been settled and payment has been made to the client – but the attorney fees have been retained in the trust account for the sole purpose of deferring taxable income.

Finally, litigation expenses paid in advance by attorneys on behalf of their clients have long been treated as loans for tax purposes; since there is an expectation of recovery, they have not been deductible.  “In 2008, a new rule will allow this cost to be incorporated into a lawyer’s contingency fee – which would make it deductible,” said Gibson.

Key performance indicators

The use of key performance indicators can help law firms identify, investigate and manage emerging trends in key business activities in a timely fashion.

“Most likely, a law firm administrator is already tracking some key metrics,” said McBride.  “However, these metrics might not be the most meaningful for your firm, or might not be analyzed sufficiently to interpret trends and identify root causes.

“Generally, KPIs for law firms measure productivity of the fee earners, value delivered to the client and producer efficiency, and the profitability and efficiency of firm infrastructure,” said McBride.  “When choosing KPIs, firm must ask ‘what are the key drivers of our practice, and how can we best track and manage them.’”

  • Utilization KPIs compare a firm’s billable hour expectations with gross production.  They include utilization (average number of billable hours), blended rate (gross fees divided by gross billable hours), number of non-partners divided by number of partners, and utilization rate (number of billable hours divided by total producer hours).

“Utilization KPIs can indicate an excess or shortage of capacity, an inappropriate percentage of time being spent on administrative activities by fee earners, or work that is being inappropriately leveraged within the firm,” said McBride.

  • Realization KPIs measure the value delivered to the client and the efficiency of producers.  They include write-downs (produced billable fees not billed), net fees (gross fees less write-downs), realization percentage (net fees divided by gross fees), net fees per partner, and net fees per full-time employee (net fees divided by total FTE).

“If a firm’s write-offs are too large,” said McBride, “you may be discounting work in order to win it.  If write-offs are too low, it is usually an indication that the market will bear a higher fee for your services.”

  • Margin KPIs can be used by law firms to measure profitability and efficiency of operations.  “Cash is king – the lifeblood of any professional service organization,” said McBride, “so keeping a close eye on the efficiency and effectiveness of billing and collection activities is critical.

“It is important for firms to understand how well the current structure can support a financial return that allows the firm to reward its people and invest in continuing practice development,” said McBride.

These metrics include salaries and benefits/net fees, other operating expenses/net fees, days in accounts receivable (average AAR/(net fee/365), days in unbilled work in progress (average unbilled WIP/(net fees/365), collection percentage (fees collected/fees billed), average unbilled WIP/gross fees, and a listing of incurred but unpaid expenses.

Once a firm has established its KPIs, it can track and analyze trends.  Benchmarks and interrelationships can be established and used for goal-setting. “Then, administrators and managing partners can “read between the lines” to assess difficult-to-measure activities like leadership development and client satisfaction,” said McBride, “correcting behaviors or activities that are counterproductive to the firm’s strategic and financial goals.

“Don’t try to track all of these KPIs,” said McBride.  “You will get hopelessly bogged down in detail.  Pick four or five that you find most useful.”

Strategic planning

Strategic planning is an ongoing process undertaken by a law firm’s management team to identify where an organization wants to be in the future, and how it plans to get there.  This plan should be reflected in the firm’s one-, three- and five-year budgets.

“Without planning,” said Windle, “law firms tend to focus almost exclusively on today’s pressing issues and not on the future of the practice.  They work in the business, not on the business.”

Strategic planning should be a multi-year process and is often most effective when facilitated by an outside consultant.  “Most firms assume they will accomplish their strategic objectives in the expected timeframe, “said Windle.  “If you choose five things you’d like to accomplish over three years, you are doing very well if you accomplish just three of them.  Deep change takes more time than you think.”

The strategic planning process can be used to determine a firm’s strategic competitive advantage.  “It can also be used to plan for succession, partner ins and outs, increased billings and profitability, new service or geographic offerings, marketing, office space, people (planning, recruitment, retention and culture), technology and governance,” said Windle.

As financial deadlines draw near, law firms should examine how structural changes like choice of entity affect taxes.  They should also examine how strategic changes like the use of KPIs and strategic planning can lead to improvements in a firm’s bottom line.

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About the Author

Janet Ellen Raasch is a writer and ghostwriter who works closely with lawyers, law firms and other professional services providers – to help these professionals achieve name recognition and new business through publication of keyword-rich content for the Internet as well as articles and books for print. She can be reached at (303) 399-5041.

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