How are law firm owners paid? Salary? Draws? Pass-through expenses? Here’s how to track your total owner compensation so you’ll know if you are getting paid what you deserve — and what it really costs to run your firm.
We get a lot of questions from law firm owners that go something like this:
- How much should I be spending on marketing?
- How much should I be spending on my people?
- How much should I be spending on … ?
What they’re really asking is this:
“How much should I be spending on other stuff in my law firm so I can know how much I should be getting?”
And it’s a great question: What should you be paid for the time, effort and risk you’re taking to be the owner of a law firm?
Accounting for Your Total Owner Compensation vs. Salary
First, let’s look at how you get compensated because, unlike an employee, your total compensation doesn’t show up on your W-2.
How are law firm owners paid?
Law firm owners generally get paid in three ways:
- Law firm owner salary. Yes, this is what is on your W-2.
- Draws, distributions or guaranteed payments.
- Personal expenses run through the firm. Don’t deny it, most of us do it, and I really don’t care as long as your tax accountant feels comfortable filing your taxes.
Your total owner compensation is made up of these three items. So, when we talk about what you as an owner are getting paid, we’re talking about these three things.
Keeping Tabs on Your Current Total Owner Compensation
The problem is this: During the year, most owners can’t tell what they’ve been paid or how much it’s really costing to run the firm.
While draws, distributions and guaranteed payments show up on your balance sheet, you have to do math to see how much the number has changed from month to month. What a pain!
And, let’s be honest, it’s hard to tell how much of the office supply expense was actual office supplies and how much was, say, those Nerf guns you got from Amazon. Or the difference between a plane ticket you bought to fly to a CLE and the one you bought to go away for spring break.
The Fix: Adjust Your P&L Statement to Show Your Total Owner Compensation
As a company, CathCap struggled with this for a while. Then we hit on a solution that makes accountants crazy, but really helps law firm owners understand their total owner compensation and how they are benefitting from their firm. How? We rearranged their P&Ls:
- We took all the expenses owners run through the business and recategorized them as “Other Expenses.”
- And we took the Draw/Distributions/Guaranteed Payments and did the same thing.
This one really makes accountants twitch because we are taking something that normally, traditionally and legally is a balance sheet item and moving it to the P&L. I’ll stop here for a moment while you call 911 to resuscitate your accountant.
Now your Profit & Loss Statement looks something like this:
Revenue | $1,000.00 |
Payroll | $300.00 |
Marketing | $100.00 |
Overhead | $200.00 |
Net Operating Income | $400.00 |
Draws/Distribution | $200.00 |
Owner Travel | $150.00 |
Owner Office Supplies | $50.00 |
Home Office Expenses | $20.00 |
Total Other Expenses | $420.00 |
Net Income | ($20.00) |
These changes show what it really costs to run the firm. (Your salary is still a payroll expense because if you weren’t there, they would have to pay somebody to replace you.) It also displays very clearly what you, as the owner, are taking out of the firm. In this case, as shown on the bottom line, it is more than you made in salary that month.
Rearranging the P&L also helps you avoid pulling too much out and “starving your firm,” which we discussed in a previous “Profits Over Panic “column.
There’s a phenomenon that seems to occur at the $1 million revenue mark, once a firm is finally turning a profit. We’ve noticed that owners start taking all the money out of the firm — and it is easy to see why. They haven’t been on a vacation, bought a new car, or done any house maintenance for years. Now that they are “successful” it’s time to do all those things. By taking so much money out, though, they are starving the firm of the cash it needs to continue to grow.
In the example above, you have actually taken out more than you made, which means your firm has taken on debt to pay you personally. Unless you rearrange your P&L as we do for our clients, it is very hard to see when you are starving your firm.
Now that you can see everything you are taking out of the firm, let’s answer the question of how much you should be getting paid.
I’m going to use the most famous attorney phrase of all time: It depends.
Total Owner Compensation Is on a Sliding Scale
The more you grow, the lower your percentage becomes. This is because in the beginning, when you are small, you do the vast majority of the work yourself. So not only are you being paid to own the firm, you are being paid to grind out hours. As the firm grows, your job changes. You do less legal work and more marketing and management. Your contribution to the top-line revenue is still important, but it is a much smaller percentage. So the percentage you take out is also smaller. But never fear, a smaller percentage of a large number is still more money than a large percentage of a small number.
Check out the chart below to find your suggested total owner compensation. If you aren’t getting that, you might want to make some changes so that your firm becomes more profitable.
Total Owner Compensation Percentage based on Total Annual Revenue
Illustration ©iStockPhoto.com
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