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New partners and old partners alike often have questions about how capital accounts work in a law firm setting. In this article, I will summarize some of the key issues in hopes that it may provide insights to those struggling with how to establish or administer these accounts for their partners or shareholders.

There are generally two types of capital accounts. Cash basis capital is generally contributed and represents the amounts initially paid by new equity owners upon their admission and additional amounts paid in on an annual basis as cash needs arise. It is also possible for cash basis capital to be "earned" either in the form of undistributed profits in a partnership or PLC setting or as increases in retained earnings in a PC environment.

Annual amounts, both for new and existing owners, are usually contributed based on some cash flow projections that the firm makes simultaneously with the preparation of the annual budget. If the firm needs total capital of $1,000,000 and it already has $800,000, then the capital call for that year is $200,000. If I am a 5% owner, my total capital should be $50,000 (5% x $1,000,000). If I already have a balance of, say, $40,000, then my contribution for that year will be $10,000. If I happen to be a brand new partner, coming in at 5%, then my total contribution would be $50,000. When I terminate from the firm for whatever reason, this amount is returned to me in full or increased or decreased by the changes that may have occurred in the firm's equity accounts.

In most firms, the capital percentages are tied somewhat to income percentages. This means that older partners with high capital balances who begin taking reductions in compensation could actually receive refunds, which are paid to them tax-free. If the amounts are not tied together, then a firm could pay interest on capital which ends up making everyone whole.

There are many firms that do not tie capital percentages to income percentages, do not have annual capital calls, and in some cases do not even require any contributions from new partners. This latter group are firms who are virtually owned by the bank and have huge debt either in the form of permanent debt or lines of credit.

It must be emphasized that items such as client cost advances, fixed asset purchases, and debt repayments must come either from cash generated by net income or through capital contributions. If from net income, it means that income is earned for which there is no cash to make a distribution, thus leaving the firm or the individual partner with a tax liability and no cash to pay the taxes. This is a situation that no firm wants to have; thus, the need arises for some type of ownership capital program.

The second type of capital is accrual basis capital, which is "earned" as opposed to being contributed. A common term for this is the owner's interest in ICS which represents the Investment in Client Services. It is just that: An owner's equity interest in services, either in the form of work-in-progress or accounts receivable that has yet to be converted into cash, factored by some realization percentage geared to the historical realization factors of the firm. It can also be referred to as "deferred compensation." It is inventory as defined in the service profession. Unlike a business that manufactures a product for inventory and recognizes income when the item is sold, when a time entry is made a sale has been consummated. As an owner, I should get credit for that sale. The fact that it has not been paid in cash is irrelevant to the recognition of the revenues. For those firms who do not keep time records, this amount is represented by the value of unsettled cases, factored for the expenses necessary to get the cases to their ultimate conclusions.

There are some firms who also include accounts payable as an offset against this. However, since these amounts generally turn over each year and are not significant, they are normally not included. If the firm owns real estate which is included within the firm (something that is not recommended), then the difference between the market value and book value may also be taken into consideration. Offsets could also include the value of the office lease, significant pending malpractice claims, etc.

In most cases a partner comes into the ownership class with a zero interest in ICS and accumulates it during his lifetime as an owner. The increases (or decreases) are either added to or subtracted from each year's balance to get a new balance, based on the owner's income percentage. Thus, if I am a 5% owner, and the ICS increases $200,000, I get $10,000 added to my prior year balance.

Getting a system like this started is always a problem, but there are many ways to do this. Whichever way you choose, there need to be certain safeguards built into the system so that the firm does not run the risk of being bankrupted with a large exodus of partners with huge amounts of accrual basis capital accounts. These are also outlined in those articles. One popular means of protection is to purchase whole life insurance, the proceeds of which go to the existing partners at the time of death. Although the premiums must be paid with after-tax dollars, the protection this affords against significant cash drains more than offsets the tax ramifications of this type of policy. It is now possible to purchase insurance that has automatic increases built in so that the benefit increases as the deferred compensation balances increase.

There are some firms that require partners to buy into the accrual basis capital accounts, in effect "purchasing" amounts from other partners. This is not a good idea since the amounts of the contribution become so large that no one can ever afford to become a partner. This could also become a severe detriment to lateral hires or merger opportunities.

Hopefully this will give you a start as you deal with this very critical issue in your firm. Have a good accountant on hand or take a look at some of the many good sources on the subject including Partner's Report which covers these issues regularly (e.g., "Accumulating Equity in a Professional Service Firm" and "Who Owns Your Work-in-Process and Accounts Receivable").