Not unlike many of my colleagues, I'm spending what is turning out to be an amazingly beautiful Spring weekend in the Bay Area preparing tax returns due next week - most specifically those of my law business, Confluence Law Partners.
What I've discovered is that there are key components of Confluence's model that don't fit neatly within standard accounting practices, resulting in higher bookkeeping and tax preparation costs and exposing me and the firm to potentially higher tax liability.
While its going to take some time for the new normal shop to reduce bookkeeping and tax preparation costs, there are some things that can be done now to protect against inflated tax liability. Furthermore, on reflection, its not surprising that current bookkeeping practices are not easily applied to the new normal model's aggregation of outside legal and non-legal services; status quo bookkeeping practices are directed to serving insular status quo hourly law firms that don't rely on significant outside collaborations to deliver legal services and whose model dissuades its lawyers from using outside legal services. More after the jump.
So what are the components of the Confluence model that are creating problems in connection with bookkeeping and taxes?
Confluence, on a case-by-case basis, forms small teams of skilled trial lawyers drawn from BigFirm practices and bills aligned fees (i.e., flat fees or other non-hourly based fees which, unlike hourly based fees, are aligned with clients' economic interests). Typically, this means that myself/Confluence and a senior attorney from another firm (see our case studies) jointly enter into the engagement agreement with the client. The engagement agreement sets out an agreed flat fee and schedule for payments of the fee in installments over time. (Typically there also are success rewards if the client wins, but that is another discussion.) The engagement agreement also confirms that Confluence and its partner firm will each take a certain portion of the installment fee with the remainder to be allocated by agreement between counsel.
The client is clear on which throat to choke - we spell out in our engagement agreement who will serve as lead counsel; usually this is a function of whether it was my relationship or that of my colleague that brought in the work. Likewise, the client gets one bill for all fees and all disbursements from all counsel.
Finally, Confluence sets up an interest bearing money market account which receives all client payments of fees and disbursements pending distribution into Confluence operating accounts or transfer into the bank account of the collaborating firm.
So where is the tension with standard accounting practices and what is the solution?
There are several areas where the Confluence model and standard accounting don't mesh as well as they should. We've flagged a couple of these areas, plus laid out our solution:
- Since the client gets one bill from Confluence, under standard practice, Confluence books as income 100% of the fees paid. Of course, not all fees go to Confluence; instead, a portion go to the associated counsel and their firms. The standard practice of Confluence booking 100% of fees, if not addressed, creates an unduly inflated net income and consequently an unduly high tax liability. Solution: Confluence nets out as an expense the transfers made to associated counsel for their share of fees.
- Holding back a portion of each installment fee paid by the client (and held in a Confluence account) presents an additional challenge. By definition, the holdback portion is not immediately distributed, so that the solution of netting out as an expense the transfers made to associated counsel is not applicable. Again, so long as the holdback remains in a Confluence account, it results in an unduly inflated net income and consequently an unduly high tax liability. Solution: Confluence characterizes all client payments into it's dedicated client account as pre-paid or unearned monies pending their distribution out of the dedicated account to Confluence or other associated counsel.
- Standard accounting practice is to book as part of lawyer income all invoiced disbursements that are reimbursed by the client. Likewise, standard accounting practice is to net out of income as an expense all specific payments made by Confluence to cover the disbursements. The theory is that the disbursement payments made by Confluence (booked as expenses) wash out the disbursement payments made by the client (booked as income) so that, at the end of the day, Confluence's taxable net income does not include any payments made by the client to reimburse disbursements. The problem is that not all of the disbursements that appear on the bill submitted by Confluence were incurred by Confluence - this is a consolidated bill that includes disbursements incurred by other firms on the team. Under standard practice, Confluence's income is credited with 100% of the reimbursed disbursements, but it nets out only the portion of those disbursements that it directly incurred, resulting in unduly high net income and therefore unduly high tax liability. Solution: Confluence nets out as an expense the transfers made to associated counsel for the disbursements that they incurred.
To be clear, none of these issues should be construed as criticism of the quality of Confluence's current vendors. To the contrary, Confluence uses the time and expense management tools provided by Sage Timeslips, virtual consulting on Accounts Receivable and Accounts Payable provided by by the numbers, and hands on bookkeeping from the great folks at Hock Company. They are state of the art. The point is that the state of the art reflects a current focus on serving status quo hourly firms that rarely outsource or otherwise collaborate with outside legal services providers as part of delivering legal services. To the contrary, the overarching incentive in the hourly firm is to keep all work in-house, even if done more efficiently and at a lower cost by persons outside the firm.
I don't have expertise in accounting, bookkeeping or tax laws. I cannot offer legal opinions interpreting their governing standards and laws. This said, I've counseled in-depth with such folks, not to mention that I'm responsible for paying their bills, and therefore have some immediate and direct experience regarding what is and is not working in the back rooms of law firms implementing new normal models for delivering legal services. I welcome any critique of standard accounting methods that I've identified as not accurately capturing Confluence's model, as well as any critique of the above suggested ways to make sure that the tension between accounting standards and delivery model do not end up unduly increasing tax liability.