Calculating an equity partner’s income
When equity partners in a law firm (or those whose spouse is a lawyer) enter divorce proceedings, there are a number of complex considerations relating to the disclosure of partnership capital and income in the financial proceedings.
Both parties need to provide full disclosure of their financial circumstances when they divorce (usually on a document called ‘form E’). If the financial disclosure is presented properly straight away, it can save time and money overall. It also means that settlement discussions can take place and makes alternative dispute resolution methods more likely to be suitable.
When joining a law firm partnership, a partner is usually required to contribute capital to the business. For a junior or salaried partner, capital contributions may be minimal or even not required. For a senior or equity partner, however, the capital contribution can be significant.
The capital required for a new partner’s contribution is usually obtained by them taking out a specific partnership loan. When considering financial disclosure in divorce proceedings, it is necessary to confirm whether the capital contribution was met by a loan. If so, both the loan and the capital held in the firm should appear on form E and they will effectively cancel one another out.
Some law firms have revolving credit facilities. This is a loan taken out by the firm, rather than an individual partner, and it reduces the need for individual partners to contribute. However such a facility would be guaranteed by the partnership and therefore each partner is allocated a portion of the liability. Some partners can also be asked to make extra capital contributions throughout their membership, usually via their income. Such extra capital contributions will be owed to the partner (and not cancelled out by a corresponding loan), usually on retirement.
In divorce or dissolution proceedings, it is important to understand what capital entitlement a partner has in their firm; whether all or a portion of this has been met by a loan and whether there is any additional capital or undrawn profit entitlement payable. Depending on when and how the capital payments were made, funds held by the law firm on the partner’s behalf may (or may not) be an asset of the marriage which forms part of the pot for distribution. The fact that undrawn capital exists does not in itself mean that the parties can benefit from it straight away. There may be restrictions on the law firm partner accessing the capital which in turn affects if, when and how it should be distributed between the parties.
Divorce lawyers typically look for the following as part of financial disclosure in divorce proceedings:
- a partner’s profit distribution statements for the previous three financial years;
- anticipated distribution or cashflow statements;
- the firm’s remuneration policy;
- the partnership deed; and
- a letter from the firm’s finance partner or director summarising the remuneration position.
A law firm partner’s remuneration is usually linked to either a traditional lockstep method or a modified points-based system. Partners are likely to be attributed a certain position on a lockstep ladder and allocated a number of lockstep points depending on their position on the ladder. Commonly, the more senior a partner is or the higher their financial performance, the higher they will be on the lockstep and the higher level of profits they can take home. If certain financial targets are met, a partner may be awarded a higher position on the lockstep. Each year a partner should be able to confirm their historic income and estimate their anticipated income based on their lockstep points and the value per point.
Some firms also have additional merit-based points allowances. If so, details will be needed of the criteria to be met in respect of those points and their value. Family lawyers advising a law firm partner or their spouse need to understand the pay structure and advise on arguments raised about a law firm partner’s performance and assertions which may need to be made about their move back down the lockstep and the impact this has on their future income/share of profit.
In terms of income, partners are entitled to both an amount of drawings each month (the level of which depends on the lockstep position) and separate profit distributions, which are the balance of the profit they are entitled to having taken drawings on a monthly basis. Drawings are payments in advance of an anticipated share of profit, whereas profit distributions are payments of the balance of profits not yet received. Given this, profit distributions usually relate to profit for the previous financial year (or older).
It is important to understand how this financial information is displayed on the form E and that there could be a difference between earnings (against which income tax and national insurance is calculated) and amounts actually paid/received in a financial year. For high-earning partners, this is pertinent because amounts received after separation may be subject to arguments about post-separation accrual, which means that the family courts treat such funds differently from amounts earned or received during the marriage. It is also relevant to arguments about meeting income needs and liquidity where a spouse is seeking maintenance from their lawyer spouse.
Most law firms estimate the amount of tax that a partner is going to have to pay on their profit entitlement and the firm reserves funds in a tax account to pay tax on a partner’s behalf when due. Partners complete a tax return which will set out the income tax and national insurance due.
Questions may need to be asked in respect of the tax reserve to ensure nothing is owed to or by the law firm partner which was not taken into account at the time of disclosure and settlement. If funds are subsequently paid out (because too much was reserved for tax) or owed (because not enough was taken), this could turn out later to be unfair on one of the parties when it may be too late to do anything about it.
Partnership income is not straightforward and the net monthly sums available cannot, like for many employed parties, easily be identified on a payslip. Lawyers involved in divorce proceedings (and their spouses) need to understand their financial position in detail to help ensure full and proper disclosure and to enable their family law advisers to take a view on whether particular arguments about affordability, liquidity or non-matrimonial assets need to be run.
Connie Atkinson is a senior associate in the family and divorce team at Kingsley Napley LLP