Are professional partnerships on life support?

I recently met with the Managing Partner of a mid-tier legal firm to discuss the struggles he was facing in trying to build a successful partnership, including attracting and retaining great people, optimising working capital, maximising tax efficiencies, retiring debt and funding investment. What quickly became evident was that he was focussing on smaller, tactical changes within the partnership framework to encourage growth but hadn’t focussed on the structure itself.

At the end of the conversation I proposed that the partnership model might not be the best option for his business. This might come as quite a surprise but firms that have traditionally been built upon a partnership model can be just as successful, if not more so, once the shackles of a partnership model are loosened.  

Issues with the partnership model

The inherent nature of a partnership is that partners pay tax on all profits, whether they are paid out or not. As such there is a reluctance to leave funds in the partnership on which tax has been paid, and therefore practices are funded by either debt or partner capital. Considering excessive levels of partner capital can be an impediment to attracting partners, debt is usually the most common funding option.

Ramping up debt levels is not a permanent solution, although it can be masked in a growing and seemingly thriving practice. However, when there are changes in business cycles, profitability levels are impacted and cracks can emerge. Banks may want the debt amortised or partners could exit the business – removing their capital and leaving less partners to manage a greater debt.

In addition, a partnership structure also comes with some level of inflexibility. Yes, there are service trust arrangements but there are also real challenges in optimising the tax efficiencies in accordance with ATO guidelines. Consider that in a partnership model partners pay tax at 47% on profits that are required to be reinvested or used to retire external debt. This kind of inefficient tax outcome for partners can make it more difficult to attract and retain talent at this senior level.  

Doing it differently

When looking to move away from the partnership structure, you could look to models such as incorporation, a partnership of trusts or an Everett assignment.  We are certainly seeing more mid-tier firms incorporating and I know the managing partner I spoke to recently is looking to pursue such a strategy following our discussion.

If you are setting up a legal firm from scratch, then you would almost certainly do so within an incorporated model. If the firm is currently operating as a partnership with a view to considering incorporation there are some threshold issues that would need to be considered first, including tax issues, stamp duty issues and safe harbour provisions.

Benefits of incorporation

1. Maximising tax efficiencies. An incorporated structure maximises tax efficiencies that are available which in turn means the partners tax outcomes are much better, being split between both the partnership profit share and dividends.
2. Attracting and retaining great people. A flow-on effect of maximising tax efficiencies is partner retention. An incorporated structure, where tax is paid at 27% or 30% and ultimately moving to a 25% rate, is significantly more efficient than one where, as mentioned above, the partners pay tax at 47% on profits that are required to be reinvested or used to retire debt.
3. Company growth. In this structure, there are more options when it comes to funding partner investment. After company tax is paid (say 25%), there is the remaining percentage of profits (75%) earned that can be accumulated to fund investment, underwrite the opening of a new office or business unit, etc. As the shareholders only pay tax on dividends declared, the firm can agree a strategy to retain profits to fund such activities. Personal tax need only be paid on profits paid out of the practice company. Such a structure encourages growth.

The cost of sticking to the status quo

There are many large accounting and legal firms operating very successfully under a partnership structure. Their circumstances, growth model, debt structure, capital management and future capital value are different to a mid-tier or smaller practice.

Most mid-sized firms work on a different foundation. Partners tend to look to both income and capital value in evaluating the return for risk and effort and expectations arise accordingly. Trying to emulate the structure of larger firms – no matter how good your partners and your services are – can stop your firm in its tracks. However, finding the appropriate structure for your firm can support consistent and sustainable growth, provide security and protection for partners, and attract the right talent to help your firm flourish.