Big Law Seizes on Promotions That Bring Big Tax Bill, No Profits

The meteoric growth in law firm nonequity partners often comes with a side effect attorneys dislike: thousands of dollars in health and tax costs without the large profit payouts full partners get.

Several Big Law firms treat nonequity lawyers as full partners for tax purposes. That means they saddle them with Medicare, Social Security and health levies the lawyers didn’t face as associates.

With the added costs, financial planner Eric Scruggs said his nonequity lawyer clients’ take-home pay is only marginally better than associate wages. “The increase in total compensation from the bump in salary and bonus potential is washed out,” he said.

The costs have given law firms and their employees something to consider as more of the operations create nonequity tiers to retain talent and boost profitability. Nearly half of partners at the 200 largest law firms by revenue were in the nonequity classification last year, up from 40% in 2013, according to American Lawyer data.

Some nonequity partners get extra compensation in recognition of the costs, while others persuade firms to change their tax classification because of the expenses. Still others get used to the change, enjoying the status of being called “partner” and realizing there are other tax deductions they can take.

Sheppard, Mullin, Richter & Hampton has a “partnership college” to help lawyers adjust to the new tax status. “We make sure we mitigate any risks,” said Luca Salvi, chair of the firm’s executive committee. “It’s an adjustment because it’s another way of life. It was a shocker for me too when I became partner.”

New Status

When newly-minted lawyers join firms as associates, they are employees for tax purposes and receive Internal Revenue Service W-2 forms. When they are promoted to nonequity partners, many of them are classified as self-employed and receive IRS K-1 schedules, just as partners do.

The K-1 filer must pay full Social Security and Medicare taxes, while employers cover half those costs for W-2 lawyers. Scruggs said the law firm K-1 filers he advises pay 100% of their health premiums, while firms subsidize 20% to 50% of those costs for W-2 lawyers.

Along with Sheppard Mullin, firms that use K-1s for nonequity partners—or have done so in the past—include Kirkland & Ellis, Shearman & Sterling, Duane Morris, Thompson Hine and McDermott Will & Emery, according to public filings and current and former partners at those firms.

Nonequity partners aren’t always happy with their K-1 status. Duane Morris and Thompson Hine are currently facing lawsuits.

Duane Morris nonequity partner Meagan Garland claims that K-1s resulted in her making less money due to the added tax burdens. Former Thompson Hine nonequity partner Rebecca Brazzano called the nonequity partner moniker “a meaningless title more akin to an albatross.”

The two firms declined to comment. Duane Morris has said the firm “strongly” disagreed with the allegations, and Thompson Hine has said it doesn’t publicly discuss partnership agreements.

‘Better Way’

McDermott Will & Emery stopped issuing K-1s for nonequity partners—which the firm calls income partners—in 2020 and switched to W-2s, firm chair Ira Coleman said.

“We talked to our income partners and our income partner committee, and they said there’s got to be a better way to do this,” Coleman said. “Maybe it’s not the greatest thing in the world to have to file in all these states and have all these administrative burdens.”

The firm incurred expenses, though he said it was worth it. “Income partners are one of our most valuable assets,” Coleman said.

Kirkland & Ellis, which pioneered the nonequity partner tier, issues K-1s for non-share partners, according to two former partners and one current partner who requested anonymity to discuss the tax classification. The firm last year increased pay for non-share partners, offsetting the added financial burdens of K-1s, one of the former partners said.

Shearman & Sterling also used K-1s for nonequity partners, according to a former partner at the firm who requested anonymity.

Kirkland and Shearman & Sterling declined to comment.

Tax Ambiguity

Ambiguity in the Internal Revenue Code allows law firms to pay nonequity partners a “guaranteed income” while listing them as 0% equity owners, said Corey Noyes, founder of Balanced Capital, which provides tax consulting for lawyers. While Big Law firms are large operations—95% of the 100 biggest topped $500 million in revenue last year—they can save in the single digits of millions of dollars annually by classifying employees as K-1 rather than W-2.

In 2024, Noyes said firms could save 7.65% of Social Security and Medicare taxes for K-1 partners on their first $168,600 of salary, and 1.45% on income over that. These savings would collectively top $2 million for a firm with about 140 nonequity partners.

Aside from the increased tax burden, a greater cost for rising nonequity partners comes from having to fully subsidize their own health care. For a high-deductible family plan, this could mean an additional $14,400 a year out of pocket, Scruggs said. However, self-employment insurance deductions for a partner with a marginal tax rate of 35% could subtract about $10,000 a year, he said.

Changes in the timing of compensation can make the first few years as a nonequity partner challenging, said Rebecca Stidham, partner and team leader for the law firm services group at advisory firm Withum. “If you take a survey of first year partners, a number of them would say they break even or they are worse off,” she said.

But K-1 lawyers can deduct unreimbursed business expenses from their tax obligations, said Ronald Shechtman, outgoing managing partner of New York-based firm Pryor Cashman. “With people working from home now, that opens up a great deal of deductible expense,” he said.

Still, lawyers must ensure the promotion pays, consultant Derek Barto said. “When you’re going from W-2 to K-1, a 10% raise isn’t going to cut it.”