Partnership Accounting: What Changes When You Add a Partner to Your Firm

Welcome to Accountants Law Pod, where accounting professionals and law firms converge. Hosted by Lynda Artesani, Sarah Prevost, and Steven Libhart.

Welcome back to the podcast, everyone. Hi friends, we're all back together. You guys were traveling.

I didn't know you guys did it while I was gone.

That's cool.

Yeah.

Yeah, Sarah and I did it while you were gone.

Wait a minute, let's go back.

We did the recording session of the podcast. So Steve was, uh, in Nebraska.

I was in Nebraska.

Lynda was flaunting about. She was in Europe going around.

Switzerland. Switzerland.

That's all. How was it?

It's pretty. Yeah.

Are you talking about your hair today? Which, which one?

No, it was mountains, mountains and lakes, and it was pretty.

But did the lakes have water?

It's not Paris. And it's not Italy.

Yeah.

It's not France. It's not Italy. It's different.

Were there castles?

No.

No.

No.

Was there Swiss cheese?

I got to see a waterfall from behind, which looks like the front. And we waited in an hour and a half line for that. I waited in a line for an hour and a half to see that. And, and the guide kept going, do you wanna take pictures here? Do you wanna? It was so cold. And then I don't need to take 50 pictures of the back of a waterfall. I, you know, it was okay. It was expensive. It was expensive, but hey, I've been, I won't be back.

Well, your pictures were gorgeous though.

The pictures are beautiful. I mean, the, the, the country itself, especially we took a hike up to, um, we took this hike, we took this long ride up and we went up on a ca— cable car. So we were at like 2,000 feet and then we went up to 5,000 feet and then we climbed another 2,000 feet.

Wow.

So, but the, To get up to it, it was like this long hike and there were cows. The cow— did you see the picture of the cow I put in the chat?

I did.

Yeah, it posed for me and, um, I could have pet him. He was so, so pretty. And then we got to the very end and it was like the lake walk. And I'm like expecting something fabulous after this, you know, 2-hour walk. And it was a lake. And then turn around and go back though. And now you're getting the striking views because now you've climbed 2,000 more feet. You're getting the striking views of Most of those pictures came on the walk back because the views on the way up were pretty, but the views on the way back were just amazing. So, and it, the everywhere you made a turn, the mountains kind of like changed and the shadows changed.

It was really pretty.

That's so cool.

Nice.

Speaking of changes, we're talking about partnership accounting and what changes you need to add when you add a partner. Oftentimes we hear this a lot where Where firms will, you know, start solo or they'll have an idea of like a colleague eventually that will join them and change happens. And then how do you handle the change? What's a fair split? How do you look at this? So you segued us, Lynda. Look at that. Yeah, perfect. And, you know, Steve floating down the river in Nebraska, we could just float down the river.

That I want to see pictures of. I mean, yeah, the mountains were cool, but I want to see Steve in his little, uh, whatever he was in.

It was a big Big stock tank. Talking about cows, I was in the stock tank. So yeah, there you go.

Well, okay. So in your experience, both of you, I mean, Lynda and I are more aligned because we see this quite a bit.

Because our experiences together.

Are together. Yeah. But, uh, when, when a solo firm moves to a multi-partner and/or, um, maybe another way to look at this is moves into another, like firms join together and maybe one firm has a partnership and the other partner's joining in. And so now it's 3 partners? Yes, please tell me.

So my experience, I'm going to jump in right away on this because I've worked in law firms and I've been on that side of the fence where they merge and then they merge and then they merge and, and change. The very first thing, get a copy of their partnership agreement.

Yeah.

Read it front to back, make notes, put stickies on there, whatever you need to do and have conversations. So you are, You have real clarity on what they intend to do. That's going to drive everything that we're doing on the bookkeeping side.

Yeah.

And I think sometimes, and this is our experience, Sarah, like you, you can meet somebody, an attorney, and you go and talk to them and they're like, well, I'm taking on a partner. I decided I wanted to expand my business and get more work and take in this other practice area is usually what we see. Then they come in and then you start, we start asking the questions to Steve's point. On the bookkeeping side. And then we're getting that, like, you can tell as you're talking to them that they hadn't thought of those things.

Right.

Yeah. And then they're like, oh, key person insurance is a great example. Now you got to consider that. Or my other favorite one, and I can remember this clearly, was what did the person bring into the business? Like, all right, they're bringing a book of business, but was there money exchanged? And they're like, No. And you're going to give them 50%? They paid nothing and you've had this business and now you're bringing them in. And it's something that, yeah, it's kind of funny when we get those conversations going that they didn't think about maybe having somebody bring in money. What is it? Skin in the game, right?

Yeah.

Yeah.

Or the—

well, that or the— I'm sorry, I had an experience where we had a partnership Uh-huh. And it was 4 different partners. And one of them was designated the rainmaker and he wasn't bringing a set of books, but darn, was he good at marketing. And so there was a value assigned to that for him as the rainmaker. And he, boy, did he grow that firm.

That's what I was just going to say.

That was a good one to kind of—

Yeah. Because the book of business is also of value when you're rolling it in. It just depends on maybe the The pie of each one. And then I think, Steve, you hit it on the head, is the value of you as an individual. Because I've seen this, um, where I, I know somebody who was a solo firm and this individual was, is truly a rainmaker. It just knocks it out of the park. Merged into a firm, eventually didn't work out, went back out, went with a partner back out.

Yeah.

And had the equity split and the, you know, we knew an S corp, they knew this, they wanted this for themselves. They knew an S corp was going to be the style that they wanted to be in as far as an equity structure. So with that came those parameters.

Sure.

And things have evolved and shifts have been made. And that's where I think the kind of the change of understanding, to your point, Steve, you have to look at the operating agreement. What is the operating gain, if you can get your hands on it, or have, like Lynda's saying, the conversations, ask the questions. Sometimes us just asking the questions gives that moment of pause because we, we never know. People will say this, I'm, you know, a partner in a firm. Well, are you the equity partner or the non-equity partner? What, what are you in the firm exactly?

That's huge. That's very important. I'm glad you brought that up.

Really important.

Yeah. So, and I, you know, in looking into this a little bit, I thought this was interesting because I know that when we talk about entity types and then the structure and the payout structure, because we're so used to seeing originating responsible, we've seen eat what you kill, we've seen the true business model, the partnership regular model. And there was something I found I've never heard of myself, but maybe you guys have. Let me see if I can find it. It's called the lockstep model.

Oh yeah. Lockstep. That's old, Sarah. That's an old one.

I know. That's why I'm like, I've not—

That's a 10-year one, isn't it?

Like the 10-year one.

Yeah. That's kind of fallen out of favor because these younger attorneys don't want to wait till they're 50.

Yeah. They won't do it.

I think I've never heard it called that, the model itself. So.

Then you're not reading our blogs.

And moving on.

They come out so many that, no, I know it's an older one, but I, that is one of the things I did on different compensation models, but that's the old school one. And the thing is the younger, the younger attorneys don't want to wait and they don't like having to be the worker bee and making their way up to that. 'Cause that's kind of an old-fashioned way of doing business and they don't care for that too much.

You don't run across a lot of firms like that. They're still out there, but you don't run across many of them. Yeah. But you remember, remember the days of Yeah.

They had to work their way up. And the longer you were there, the more tenure you had, the more you elevated your way up. And so, hey, it's good and bad. I mean, if you gotta work—

It is.

And if you're not, you see the people, we've seen it with clients we've had where there are maybe 3 people in the business, but one's doing all the work and the other ones are barely contributing. And then you can see that it becomes a problem. problem with the partnership if the partnership was divvied out in certain percentages and then come to find out the other people aren't really pulling their weight and now you've got one partner doing everything and then that person resents the fact that they're having to divide up the revenue. So it's important to make sure that whatever the compensation they decide on.

Yeah.

And also a lot of times the partners, if you start bringing in more people, Your little small firm might now need a payroll because now your firm has grown and you gotta add all these people in the business, paralegals, whatever, admins to manage everybody. And now you're gonna change that you need a payroll and you're gonna get paid a salary and maybe still get bonused out, but you gotta figure out, well, how that will work because there's multiple ways, like lockstep. There's multiple ways of breaking up, you know, figuring out how to do the compensation, whether you take that net profit and divide it by the percentages or.

Yeah.

Some, there's some easy ways. And then of course you eat what you kill and there's all different models.

So. Yeah.

Yeah. You know, the more you talk about it, the more I'm like, oh, okay. We, the, the modified model is interesting because the modified model is like an allocation of collected profits into buckets. And the way it's written out here is it's got the finder, the originator, the minder, the supervising slash management individual.

The minder, the grinder, the—

The grinder, right? Yeah. And it talks about the percentages to the managing partner versus the originator naturally has a bit more in the— because they're doing the work. And then the grinder, the execution is also a bit higher because they're performing the work.

Right.

So, it's an interesting model. We see a lot of times, our experience of late is just a simple model. Just, it's just business. This is how we do it. And they, they see what revenue, they set goals to the revenue projections, but they're not, not necessarily equating out pay or compensation to that in the same way. It's slightly different.

Um, and then when there's multiple partners, somebody's got to step forward to be the one that takes care of the work, of the bookkeeping or whatever. And then so they kind of take, everybody takes their hat and for whatever their, whatever their job is to kind of step forward, there's always a managing partner, usually a The managing partner.

Managing partner. Yeah.

You have that too. I mean, there's a lot though. When you start to add people to the mix, it can be a great thing. I mean, I think of a PI firm, personal injury, that, you know, they're kind of starved for cash while they're not landing the cases or finalizing the cases. And you have a nice other practice area that somebody's bringing in steady money into the business.

Yeah.

So that they can share when the wins happen. But there's always those because it's very jagged when it comes to PI. So, that's a good complementary one. I think of that firm in Connecticut, great example, the one that the guy had the biggest, at the time, this is going back a few years, he had the biggest windfall of a case that just cost a lot of money to, and it was a class action. And at the very end, he had the biggest—

Yeah.

He had the biggest windfall, but he ended up taking on a partner to help carry that through because he needed the cash to keep the business running, to keep the people in the seats working while they were doing this work before the big cash money came in. So that's a good way to kind of complement a personal injury firm, which will have ups and downs with cash flow.

You know, in a personal injury firm, depending on the size, but let's pretend like it's a big one. You might have your rainmaker also take the dual role of managing partner. To help, you know, keep the ship afloat and keep things covered while the business is going on and you're waiting for settlements and all of that. And you reach a certain point where you have enough reserve built up that you can go ahead and afford more team and more, you know, it just, you grow it organically.

Yeah.

I mean, you see these commercials on TV for the personal injury attorneys, you know, that's the Rainmaker guy. You know, that's, That's usually the Rainmaker out there doing his thing. And, you know, I think of 2 or 3 of them here in the Denver area where I am that are huge, that have the Rainmaker, and they also have managing partners and they have a whole stable, if you will, of paralegals and everything, but they started small.

Yeah. I mean, I remember riding through Vegas with Sarah or Nevada. We were going through Nevada and it was like on the highway and it was like just the signs for personal injury. Like there must be a ton of it there because there was so many. We were like, oh my God, look at all the law firms that are advertising on billboards because that's what usually personal injury firms do. But, you know, and then like you said in the beginning about having to make sure that the partnership agreement is done, a lot of times it's done because they're attorneys, they know how to do their own. But then sometimes we need to review it because there might be spaces in there that weren't addressed because they— and I think that might be less happening now with the implementation of AI. It will probably kind of COVID what maybe— Yeah. Gaps. You really wanna cover all your bases when it comes to that. You wanna make sure that everything's accounted for when the people come in, how the percentages are gonna go down. Is it gonna be equity? Is it gonna be not equity? And what happens when the partner leaves?

Mm-hmm.

Mm-hmm.

That's something that you have.

You've got to have that in there.

Yeah.

Yeah.

The exit strategy.

Yeah. It, sometimes it's not, um, it's clearly defined depending on if you're merging into a firm and they've already got it established, right?

Yep.

But when you're starting out, that's not your intention. You don't have those things in place per se.

Right.

So then when you go to write one, it's interesting to see the thought process behind it because that's where I feel like you evaluate what you're bringing and what you are entitled to possibly at the end of the day. I do think in our experience, we don't always get to see the operating agreement. However, we, when we're talking about it and sharing our thoughts or our experiences as business owners, not in the tax professional bucket, understanding the differences of what they're signing up for is, I feel like, the biggest hangup. Should they remain because of how they choose to pay their compensation?

Mm-hmm.

Is it more amenable for them to remain a partnership rather than sort of an S corp? entity election, or maybe some personal things are going on in one person's life versus another. Those are things that we're not going to be a part of, but the conversations kind of feel like get funneled through. Like what, Lynda, you're saying is like we just start having a conversation and that's where it's different for us as people that niche into this. I feel like we strongly understand, okay, We may not see everything, but we understand a little bit. Like you said, Steve, you work in a firm, so you have a little bit of the inner workings to know what is going on. Like, how should the end result be? Because a senior partner that eventually is going to retire, what does that rollout of change happen? How does that happen?

Yeah. Right?

So, there's like so many layers to just a simple look of like, I'm starting my law firm and I'm partnering with this person, which has happened all the time.

A lot, right? On our side, as the bookkeeping firm, we have to look at the structure, know the structure, know the percentages, know who's equity, who's not, especially when they start to tie all their numbers in their compensation to these figures because we have to break out that section. And I can never forget, Sarah, that firm we had that had 52 partners.

Wow.

And they only had, and when we picked up the file, they only had one equity section or maybe 2 or 3.

Oh my God.

And then we're like, well, where's everybody else? Because we're starting to divvy out these bonuses, tie it back to the books. And oh, by the way, most of them don't tie it to the books. So now the books don't make sense to what the numbers that the figures that are getting paid out. And then now we had to do corrections because sometimes they overpaid a partner, sometimes they underpaid a partner. And it was like, and then once you start to go down that road and you have that many partners, now you're going to lose a little bit of faith from those people because they're going to be like, well, what was going on? Why was that not?

Correct.

I thought this was correct because half the time they're doing it on an Excel spreadsheet and that doesn't always work out so well.

And, you know, we bang our heads against the wall when we see that.

I mean, Steve, I, in light of that, what she was just saying, have you ever— so this spreadsheet was very big and literally splicing and dicing on, oh, well, this person's on health insurance. Well, this person didn't opt.

Yeah.

And you literally had to, and depending on, did they add their family? Did they take off their family? Things change every month.

Oh my gosh. Yes.

And if the bill didn't line up, how retroactive can you? And if they didn't make enough money, it was just like this mess.

Or they'll add a benefit and not tell you about it.

Yeah. Yeah.

So if Nicole happens to watch this one podcast, she's going to have back nightmares because she was tasked with creating this structure and it was so big and we were trying to connect everything and it It was just the most insane thing.

Beast.

I would say it was a beast.

We did get a very big compliment. We did get it to work. Yeah, we got it to work and we got a huge compliment from, um, I forget when, if they changed tax people or if there was a change within the firm, but they honestly could not believe the breadth of workload and they took our spreadsheet That was, that was their spreadsheet. And then we, not the tax firms, but the firm took the spreadsheet, redid the data, reorganized as best we could, kept it in the same place, but kind of did a summary view. And then from there had it lay out so that we could literally tick and tie the balance sheet with these non-equity partners and then the equity firm and the equity partners inside of it. And so then the whole entire thing It took hours at that time. This was pre any AI, any unstructured data. This is like, go into Excel.

Ooh.

There was a ton of adjustments. And then at year end, we had it all tied out and then they started making changes. I was like, no, it was all, it was all set. You can't go back and tweak this now. Yeah. It was just something else.

And that was not our first endeavor. We had received yet another one that was very complex. smaller in scale. But, um, so I guess I love this, uh, you know, let's get into this niche and do this. And then you get, you stumble on the first one, then you stumble on the second one and you realize there's way more out here than, you know, more data, more knowledge, more things to learn. And I think that's the best part is that we always have to remain curious.

Sure.

In the end, we're business partners. We're, we're business, you know, people, we We see it from a business perspective as much as we see it from an accounting perspective.

So, yeah.

Well, and you know, the other, the other thing that we should layer in here, um, is the CPA, the tax preparer.

Oh, we need them.

That's why that was a big compliment, right? That we had them come to us and like, they were so happy with us because we actually had figured out the problems that were there.

Yeah. Yeah. Yeah. Well, I guess the biggest takeaway is, I don't know, our tips. I'm trying to think, recapping our tips here. Steve, do you have a recap for us on tips?

Well, the partnership agreement, part of it getting correct information on who is an equity partner and who is not. Like, you, you know, you have an attorney that works their way up the ladder in your firm and you make them partner. What does that mean?

Okay.

You know, does part of their compensation over a certain percent go towards their equity, building it into the firm? You know, the chart of accounts, which we really haven't talked a lot about, but the chart of accounts, you know, what's on the balance sheet, um, and, you know, as equity and what's on the P&L as distributions and when anomalies happen, where do they go? Um, you know, those sorts of things.

Yeah.

There's 2 or 3 examples there.

That's, those are good. You're right. We didn't really talk about that structure of that entity because you might have, or the equity, I'm sorry, you might have to build that out uniquely different than like what Lynda was referencing earlier where it's just one equity and for 3 partners, it's very unclear, uh, especially if you are moving money in and out of, um, there's intended money that needs to go back out to a partner and it's all dumped into one group. It's not easy to do it, group it by name in the transaction if you're in QuickBooks. I mean, it is better to have it itemized out.

Well, and to your, to your point about a while ago about the, uh, oh, and I just drew a blank, but, um, an example I have is there's the distributions, which normally equal each other.

Yeah.

Really? Okay.

Normally.

But then a partner takes something out, like maybe insurance for his family or an additional 401 deposit or something like that. You know, that goes in my world, that goes and lives in equity until the end of the year for the tax people to work with.

Yeah.

Um, and quite often, and I've seen this in many law firms, not just one, but, um, where they'll, they don't understand, they being the partners, don't understand why that's in equity all of a sudden. And the distributions don't equal each other for the rest of the year, you know, unless you do a catch-up in distributions and, you know, so there's, there's all those little anomalies that happen on the books that you really have to pay attention to. And then part of that includes really working with the client on reviewing the books consistently.

Yeah.

Yeah.

To catch surprises before the end of the year.

Yeah. Or, you know, if it depends, because if they're busy working firms, which I'm not saying that that is a scapegoat, but maybe finding that internal line in the sand where you can say, hey, we're entering, you know, 3rd quarter, we're going to round to the end of the year. I just need to get some time to—

Right, right.

For us to plan out, to your point, because right now, depending on where What law firm practice area they're in, what legal practice area they're in, the law firm itself is churning and they might, you know, especially if you're a smaller firm, you don't have a lot of bandwidth for some things, even though you're, you know, you're supposed to make it, right? But you might need to do that. And a lot of times for us, it, we make, we kind of look at things and we go back to the tax person because they might know pieces that we don't know.

Mm-hmm. Correct.

And we want to reach out proactively as much as we can to say, hey, can we just take a look at this and tell us what you think? And, you know, bearing in mind that we're going to, you know, get busy at end of year and there's a lot of planning that might need to happen and conversations that are not happening with the tax person because we're seeing it, but they're not saying it to the person or they don't do a regular call. Whatever it is. So it's your, like, we're all cogs in the wheel, but how we can help as much as possible as far as being stewards of that partnership, that would be great.

You're making me have flashbacks of what it's like at the very last week of December when they decide that they want to get it all tied up by the end of the year before the year is up and get the bonuses out and the fire is on, the place is on fire because they want the payments done in the year that that all this is happening and it's hectic. And then a lot of times that they're in a place where we kind of need the year, in our brains, we want to tie it up in a bow once the year is over.

So true.

But then you can't pay it. So it's stuff you have to factor in. And we have some pretty large firms that we have to do this work for. And we actually schedule that out. We do a preset meeting to kind of pre-look at it. And then at the very end of the year, we do that final, maybe a couple of weeks. Sometimes they're closed at the end of the year, which makes it easier. They close the last week of the year, like Christmas week.

So it helps a lot. Yeah. Yeah.

This was a good topic. When I saw the title, I was like, partnerships, like we're partnering with them, but we do do that. But I just thought it was, uh, I thought it was that until I started reading all the notes and I'm like, okay, that's what they mean. We're talking about adding a partner, which definitely, definitely makes a difference in your firm. And it's something that should be thought very thoroughly through before you actually make the leap to it.

Please don't call us up and go, surprise!

Yes. Or tell us like, oh, didn't I tell you 3 months ago I added a partner? No, you didn't. Oh, you changed this person to a partner, but you didn't tell us? Yeah, we kind of need to know.

We really need to know.

Kind of, kind of. Yeah.

Kind of. Yeah.

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