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Some U.S. law firms maneuver to avoid 2013 tax hit

By Casey Sullivan and Nanette Byrnes

(Reuters) - When associates at New York law firm Weil, Gotshal & Manges learned about their annual bonuses last month, the details came as a bit of a jolt - not because of the amount, but rather on account of the timing.

In a departure from recent practice, the firm said it would deliver the bonuses in January instead of December, according to an account in the legal blog Above the Law.

The change, coming just ahead of federal income tax hikes expected for 2013, looked like something of an accounting feat, with clear winners and losers - though it is a reversion to the firm's historical practice before 2009.

It exposes the associates to a bigger tax bite by shifting the income to next year, when tax rates are expected to be higher, but it reduces the potential tax liability for partners by allowing them to report higher income in 2012 before the more punitive rates kick in.

While the $10,000 to $60,000 bonuses were close to the legal industry norm this year, many associates at the 1,200-lawyer firm were not happy.

"People are definitely annoyed," said one associate who asked to remain anonymous.

A Weil spokeswoman declined multiple requests for comment.

Of the more than 10 law firms contacted by Reuters, none have followed Weil's lead in deferring bonuses, with two firms suggesting such a move would antagonize associates. But as President Barack Obama and Congress hash out the best way to avoid a wave of tax hikes and spending cuts set to automatically kick in on January 1 - the so-called fiscal cliff - partners across the country are taking other measures to protect their earnings.

The law firms' strategy involves booking as much income as possible in 2012, when rates are low, while deferring expenses to 2013 in order to reduce taxable income in that year. That is the opposite of typical year-end law firm accounting, when managers usually try to find as many expenses as possible to bring down the ending year's tax bill.

"It's tax planning in reverse, so to speak," said Kansas City, Missouri tax specialist Scott Slabotsky who said he has been advising his law firm clients to collect bills in 2012.

If the president and Congress are unable to reach an agreement before December 31, income tax rates will rise for almost all Americans. Marginal rates will revert to levels before cuts made by then President George W. Bush, which for many lawyers at big firms who are in the highest bracket - earning $388,350 and up - means a marginal rate of 39.6 percent instead of 35 percent.

Even if the president and Congress come to a consensus ahead of December 31, taxes on the wealthiest Americans are still expected to rise, which is why firms are taking action now.

There are two basic approaches. Some firms are seeking to shift more income to 2012 so the money will be taxed at a lower rate. They are doing so by asking longtime clients to either pay retainer fees up front or by redoubling the normal efforts to collect hourly bills before the end of the year.

The second variety of accounting moves deal with deferring expenses to 2013 when the write-offs will help offset higher taxes. Those expenses can range from associate bonuses to rent, pension plans, phone bills and other operating expenses.

The Kansas City law firm Shook, Hardy & Bacon usually prepays certain January expenses such as rent, IT costs and equipment leases in late December to get some of the following year's expenses off the books early, said chairman John Murphy.

This year, Murphy said he will pay many of the smaller expenses in January instead to reduce income in 2013 when taxes likely will be higher. But he did not want to defer more significant expenses such as pension plans, insurance, or associate bonuses.

"We didn't want to get into a situation where you rob Peter to pay Paul," said Murphy.

In New York, the five-lawyer corporate firm Wahab & Medenica and the 30-lawyer real estate firm Adam Leitman Bailey both said they normally try to collect what is owed by the end of each calendar year. But with the uncertainty around next year's rates, they are redoubling those efforts so as not to leave any extra money on the table for the government.

"Bottom line, we are picking up the phone and calling clients to get the bills paid... (and) making sure that November bills go out immediately," said Adam Bailey, the firm's manager.

Firms including Milbank, Tweed, Hadley & McCloy and Arent Fox said they were not asking clients to pay earlier than normal, nor were they shifting expenses to next year.

"I don't think most firm managers are buying into that kind of roller coaster ride," said John Soroko, chairman of Duane Morris. "Certainly we won't do anything to artificially push expenses into 2013."

Peter Zeughauser, a law firm consultant, said: "Firm leaders sometimes defer expenses in the hopes that next year will be a better year to sustain the cost." But he added: "The risk is great if the firm continues to perform poorly and expenses mount up."

For law firm partners, there are hundreds of thousands of tax dollars at stake. The average profits per partner in big U.S. law firms in 2011 ranged between $500,000 and $4.5 million, according to the American Lawyer. At that level of compensation, the partners' tax brackets won't change, but their rates most likely will.

For associates, who are employees, the picture is a little less clear. Their salaries typically run $145,000 to $200,000-plus, and the tax changes could affect both their bracket and their marginal rates.

The bonus deferral at Weil, where junior lawyers earn between $160,000 and about $300,000, demonstrates how that could happen. Take a hypothetical fifth-year associate earning $230,000, whose $34,000 bonus was bumped forward to 2013. That associate could be stuck with an extra $1,300 to $2,550 in taxes, depending on his or her 2013 tax bracket and if the person had filed individually, calculated David Kautter, managing director of the Kogod Tax Center at the Kogod School of Business at American University.

It's not surprising that Weil associates are angry, said Bill Sansone, a New Jersey accountant who specializes in law firms. He said some of the law firms he'd spoken to had considered deferring bonuses too, but had decided against the move as bad for morale.

"You aren't looking to upset people," said Sansone.

(Reporting by Casey Sullivan and Nanette Byrnes; Editing by Eileen Daspin and Claudia Parsons)

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