When it comes to the financial overhaul of your law firm, the profit margin is top of mind. This is what you want to see: a profit means your law firm is bringing in money. Your profit margin is your revenue, what’s left after the necessary expenses.
The necessary expenses are everything essential for running your firm. That’s rent or mortgage, utilities (electricity, phone, and internet), services and subscriptions, professional memberships, and the biggest, most important expenses: your salary and your payroll.
Because they’re the biggest expenses, how you manage those two can make a huge difference for your profit margin.
The most important salary in the firm is YOURS. This is IMPORTANT. You MUST pay yourself. Your biggest expense will always be your payroll. Include yourself in it. I don’t care what your business structure is– S corp or C corp or partnership or whatever it is. You MUST pay yourself a salary.
There are tax reasons that will require that you pay yourself a salary or you can get fined, but I am not a tax expert so I won’t go into that part. But from a business perspective, you must, must, must pay yourself a salary. And your goal should be a fair market value (FMV) salary.
I know SO MANY attorneys who are not paying themselves at all. They are taking from the firm whatever is leftover at the end of each month instead of being strategic about a salary.
I understand this because I did the same thing. I had no idea what to do or how to manage money in my firm because I felt like things were always coming and going and I didn’t know what was coming and when and what was going and when.
Why Do So Many Lawyers Not Pay Themselves?
See if this sounds sound familiar to you. I was really scared to pay myself a salary because:
- I felt like I couldn’t afford to.
- I felt like the payroll taxes were really expensive and that they would break me.
Here’s what you should think instead: Your salary is something you need. You will always come up with the money for things you need, so start with your salary! Even if it is just you, pay yourself a salary.
How To Determine Your Salary:
- What would it cost to replace you in case something catastrophic happened?
- If you can’t get up to FMV at first, start with something reasonable.
That’s it. Pay yourself, and remember to be reasonable.
I know lawyers who pay themselves a $500 paycheck. That is not sustainable – you can’t live on that amount, even with any amount of owner draws. That’s $12k a year! Make it your goal to get up to FMV, but at least start with something.
A Note on Draws
As you earn more in your firm, it feels tempting to keep your salary really low and then take high draws—this is a strategy that is often recommended because your taxes are higher on your salary than on ownership draws. However, it is a red flag to the IRS if your owner draws are a lot higher than your salary. This could make you subject to an audit.
One lawyer told me that he recommended that I pay myself no more than $30k a year and just take tons of money in draws. But my CPA and other books I have read about running finances have told me that the best advice is to pay yourself a defensible, fair market salary, and then take draws from there.
Even now, I take draws that are higher than my paycheck. But alongside my CPA and my CFO, we have decided that I am making fair market value in my paycheck that would be defensible and wouldn’t look like I’m abusing the system, despite my large draws.
As I said above, your payroll is your biggest expense. And yet it’s amazing how so many lawyers over-hire as soon as they start to make money!
I think the main reason for this is lawyers are often not good business people. We see our numbers growing with more clients and our instinct is to hire more! Most firms are not streamlined or organized, there are no systems, and often times the staff is not being maximized.
And this is the NORMAL way for law firms to run. This is how so many firms do it. I worked in a firm like that. They would suspend paychecks for the partners and cancel holiday parties because they couldn’t make ends meet.
Because of that experience, I’ve been scared to hire and I’ve read a ton of books on running a very lean business. However, what I didn’t know is that there is an actual formula that you can use to figure out if you can afford to hire someone: the salary cap and the 33%.
The Salary Cap
I’ve read a ton of business books and it’s insane that I didn’t come across the concept of the salary cap and the equation for figuring out how much you can spend on staff sooner!
Funnily enough, the salary cap originates from sports. I don’t really care for sports-related things, but this idea really resonated with me. Here’s how it works: in the NFL, every team has a salary cap, which is the total amount of money that they can spend on hiring players. Let’s say the salary cap is $100,000 in total. This means that they have to hire every single position on the team for $100,000 or less.
They have a budget, and they have to make every choice wisely. They can go for “cheaper” players in some positions and more expensive players in others. They have to decide whether to cut their excellent yet expensive players in favor of replacing them with two other really good players that cost the same.
You can’t spend $90k on one great player and expect to fill the rest of the team for $10k. You have to make smart money decisions. The problem for us is that we don’t know we have a salary cap, or that we should operate within it. Some firms have grown to have a larger staff because they have a high number of revenues, but they are cutting it way too tight with payroll and are far exceeding their salary cap.
The 33%: Your Payroll Percentage
The total payroll in your business should be no more than 1/3. That is, 33% of your revenues should be spent on salaries. That’s it. That’s a simple equation that is easy to figure out.
If you are over that, then you have exceeded your salary cap and that means that you could be putting your business in a lot of financial trouble. My firm is at about a 23% salary, which my CFO says is incredibly low, and the lowest he has ever seen. That includes my salary in addition to everyone else’s in the firm. I had no idea about a salary cap, but I am really committed to keeping our salary cap at 25% or less because I want to maximize our staff.
How the Salary Cap Benefits Your Payroll:
- You can test the numbers before hiring.
- My CFO advised us to err on the “high side” of costs, so that means adding 20% to the cost of every hire’s salary. That means that if you offer $100,000, then the cost to your firm will be $120,000. This includes payroll costs, taxes, benefits, time off, and more.
- It helps you look at the team to see if they’re performing at the highest level.
- See how you can help them step up.
- What roles and positions can you streamline? E.g., Are two people doing the same job? Or are certain tasks scattered among several people instead of each role being clear-cut and efficient?
- You can make sure that any new hires will be able to cover their own expenses and make up for any differences to your bottom line.
- Does their role contribute to bringing in more revenue than they cost?
The hard thing here is that you may have to let some people go. When you do a shakeup like this, some people may leave anyway. It’s okay, this happens. It may suck at first but you will be okay! You MUST make these hard decisions in order to have the best business that you can possibly have.
You need to get your payroll under control so your firm can reach its full potential.
What You Need
Now that you see the roles that your salary and your payroll have on your firm’s financial success, you can either try to do it alone or get professional help, which is a bit easier!
Find an Excellent CPA
Find someone who is knowledgeable and trustworthy when it comes to making these important decisions. Part of having a great business is having a team of professionals that you can rely on to help guide you through decisions and evaluate the state of your firm.
Get Help With Your P&L and Payroll
For your Profit and Loss: I LOVE Bench and I am partnered with them because I absolutely love them. If you are trying to do your own bookkeeping, stop right now and get Bench. If you aren’t doing your bookkeeping at all, then start right now with Bench.
For your payroll: Gusto has made everything so easy for us to run payroll and I highly recommend it. For me, paying myself was hard and complicated enough. I needed a payroll company that made it easy. I first started out with one through Bank of America that was telling me I had to report taxes on my own and file certain forms and all sorts of stuff that was super, super overwhelming for me. I had no idea what I was doing, and if I was going to do payroll, I needed something that would make it easy for me. That’s when I found Gusto and I have never gone back again!
For more information about the payroll equations and the salary cap, read the first ever book I’ve sent out to CEO-level Six Figure Solos: Simple Numbers, Straight Talk, Big Profit. Get yours here!
If you can believe it, I have even more knowledge to share on this topic! If you’d like to learn more about tracking your numbers, sign up for my Six Figure Solo program! Six Figure Solo now comes in three tiers – Executive, Solopreneur, and CEO. Sign up here!