Big Law Capitalizes on Promotions That Result in High Tax Bills Without Profits

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

As a result of these additional financial burdens, financial planner Eric Scruggs noted that the net income of his nonequity lawyer clients is only slightly higher than that of associates. He remarked, “The increase in total compensation from the bump in salary and bonus potential is washed out.” These financial implications have prompted law firms and their personnel to reevaluate their structures, particularly as more firms establish nonequity tiers to attract and retain talent while enhancing profitability. According to data from American Lawyer, nearly half of the partners at the 200 largest law firms by revenue were classified as nonequity partners last year, an increase from 40% in 2013.

Source: The American Lawyer

Adjustments and Adaptations

Some nonequity partners receive additional compensation to acknowledge their expenses, while others advocate for their firms to alter their tax classification due to 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 “partnership college” to assist lawyers in acclimating to their new tax status. “We ensure that we mitigate any risks,” stated Luca Salvi, chair of the firm’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 lawyers enter firms as associates, they are considered employees for tax purposes and receive Internal Revenue Service W-2 forms. Upon their promotion to nonequity 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, whereas 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 firms typically subsidize 20% to 50% of these costs for W-2 employees. In addition to Sheppard Mullin, firms that have utilized K-1s for nonequity partners, or have done so previously, include Kirkland & Ellis, Shearman & Sterling, Duane Morris, Thompson Hine, and McDermott Will & Emery, as indicated by public filings and insights from current and former partners at these firms.

However, not all nonequity partners are satisfied with their K-1 status. Duane Morris and Thompson Hine are currently facing legal challenges. Meagan Garland, a nonequity partner at Duane Morris, asserts that K-1s have led to reduced earnings due to increased tax liabilities. Former Thompson Hine nonequity partner Rebecca Brazzano described the title of nonequity partner as “a meaningless title more akin to an albatross.” Both firms have opted not to comment. Duane Morris has expressed that it “strongly” disagrees with the allegations, while Thompson Hine has stated that it does not engage in public commentary.

McDermott Will & Emery ceased the issuance of K-1 forms for its nonequity partners, referred to as income partners, in 2020, transitioning to W-2 forms, as stated by firm chair Ira Coleman. “We consulted with our income partners and the income partner committee, and they expressed the need for a more efficient approach,” Coleman remarked. “It may not be ideal to navigate the complexities of filing in multiple states and managing extensive administrative responsibilities.” Although the firm faced certain costs, Coleman emphasized that the investment was justified.

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

Additionally, Shearman & Sterling also utilized K-1 forms for its nonequity partners, as reported by a former partner from the firm who wished to remain anonymous. Both Kirkland and Shearman & Sterling opted not to provide comments.

Tax Ambiguity and Financial Implications

The Internal Revenue Code's ambiguity permits law firms to provide "guaranteed income" to nonequity partners while designating them as 0% equity holders, according to Corey Noyes, founder of Balanced Capital, a tax consulting firm for legal professionals.

Major law firms, which are substantial entities—95% of the top 100 firms generated over $500 million in revenue last year—can achieve annual savings in the millions by categorizing employees as K-1 instead of W-2. In 2024, Noyes indicated that firms could realize a 7.65% savings on Social Security and Medicare taxes for K-1 partners on their initial $168,600 of salary, along with a 1.45% reduction on income exceeding that threshold. For a firm with approximately 140 nonequity partners, these savings could exceed $2 million. In addition to the heightened tax liabilities, rising nonequity partners face significant costs due to the necessity of fully covering their own health care expenses.

For a high-deductible family plan, this could result in an extra $14,400 annually, as noted by Scruggs. Nevertheless, self-employment insurance deductions for a partner with a marginal tax rate of 35% could alleviate around $10,000 each year, he added. The timing of compensation can pose challenges during the initial years for nonequity partners, remarked Rebecca Stidham, partner and team leader for the law firm services group at advisory firm Withum. “A survey of first-year partners would reveal that many feel they either break even or are at a disadvantage,” she stated.

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

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

The Financial Challenges of Nonequity Partners in Law Firms.