When equity partners in a law firm (or those with a lawyer spouse) enter divorce proceedings, there are a number of complex considerations relating to the disclosure of partnership capital and income in financial proceedings. In this blog, we explore the common structure of partnership income and the relevant considerations in divorce proceedings.
When getting divorced, parties need to provide full disclosure of their financial circumstances, usually on a document called a Form E. If one of those parties is a partner in a law firm, it is important that specialist advice is taken about what information needs to be provided and how it should be presented. In representing a law firm partner, we work with them, possibly their financial advisor and, if appropriate, a representative from the law firm to streamline the disclosure process. If the financial disclosure is presented properly straight away, it can save the time and cost associated with dealing with lengthy questionnaires after Forms E have been provided. It also means that settlement discussions can take place and makes alternative dispute resolution methods such as mediation more likely to be suitable. When advising the person married to the partner, it is important to understand the structure of partnership income and capital so that financial disclosure can be reviewed effectively and appropriate questions asked. It is only after this that settlement discussions can take place.
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 not required. For a senior or equity partner, however, the capital contribution is significant.
The capital required for a new partner’s contribution is usually obtained by them taking out a specific partnership loan with a bank experienced in providing these. When considering financial disclosure in divorce proceedings, we need to confirm whether the capital contribution was met by a loan and both the loan and the capital held in the firm will appear in the Form E (the financial disclosure statement) 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. Such a facility would be guaranteed by the partnership and each partner would be allocated a portion of the liability. We have also seen some partners 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. We may need to ask questions about any additional capital payable during the partner’s membership, such as the reasons for this, and also what (if anything) will be repayable to the partner 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 loan and whether there is any additional capital or undrawn profit (see below) 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 impacts if, when and how it should distributed between the parties.
A law firm partner’s remuneration is usually linked to either a traditional lockstep method or a modified points based system. Put simply, the more points you have, the more profit you are entitled to.
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 higher their financial performance, the higher they will be on the lockstep. If certain financial targets are met (which vary from firm to firm), a partner may be awarded a higher position on the lockstep.
As referred to above, each lockstep point is worth a certain sum each year, which usually depends on a firm’s profit. A partner should each year be able to confirm their historic and estimate their anticipated income based on their lockstep points and the value per point.
Some firms also have additional merit based points allowances, in which case details will also 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 their particular pay structure and be able to 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 NI is calculated) and amounts actually paid/received in a financial year. For high earning law firm partners, this can become particularly important as 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 reserve 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.
In terms of financial disclosure in divorce proceedings, depending on the information provided in a Form E, we usually need to see the following:
- a partner’s profit distribution statements for the last 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.
Partnership income is not straightforward and the net monthly sums available cannot, like for many employed parties, easily be identified on a payslip. Specialist advice is needed from the outset so that we can assess and set out the financial position early and consider whether particular arguments about affordability, liquidity or non matrimonial assets need to be run.
We frequently advise clients who are equity partners in a law firm or those who are separating from their lawyer spouse and we understand the complexities in assessing capital and income in financial proceedings.
If you have any questions, please contact a member of our team of family and divorce lawyers or click here to get started online and find out where you stand.
You may also be interested in reading our other blogs about financial settlements on divorce – see HERE.
About the author
Connie is a Senior Associate in the family team and has experience of dealing with all aspects of private family work relating to both finances and children. Connie has expertise in cases involving: financial settlements; partnership, company and/or trust assets; international elements such as relocation and cross-border disputes; international surrogacy; arrangements for children; pre and post nuptial agreements. Connie is also a qualified mediator and assists as a mediator for clients in respect of all practical and legal issues surrounding family arrangements and divorce.