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Law Dept 101: How to pay your outside counsel.

Summary: Hiring outside counsel is a big step for any new business. Perhaps you need someone to look over closing documents, or want advice on how ...

Hiring outside counsel is a big step for any new business. Perhaps you need someone to look over closing documents, or want advice on how to best structure your new corporate entity. Or perhaps things have gone sour, and you've been sued for the first time--or you need to sue someone else. Whatever the situation, you have realized that you need some help, and have decided to hire outside counsel. What are the different ways you can pay your new lawyer, and are there any tax advantages or disadvantages to each method?

Methods of payment

The first, and most common, method of payment involves paying your lawyer on an hourly basis. Your engagement letter (you did get an engagement letter, right?) lists the lawyer(s) who will likely work on your matter and their hourly rate. This method gives you the most transparency, as every invoice will show exactly what your lawyer is doing every hour (or, more likely, every .1 of an hour) he works for you.

Some firms use a "blended" rate, where the billable rates of the partners, associates and paralegals are blended together to give you one overall hourly rate. If trial is imminent, this can be useful, as it lowers the partner's rate to something more palatable. However, if hundreds of hours of research, document review or due diligence is upcoming, it's the associate--at what is now a higher rate--that will be doing the bulk of the work.

If your legal issue is somewhat cut-and-dry, the lawyer may agree to a flat fee. This is great for you because you know exactly what you'll be paying beforehand. It also gives the lawyer an incentive to work efficiently, as the quicker he finishes, the more he effectively gets paid. Many lawyers are reluctant to agree on a flat fee, however, as it can be difficult to accurately estimate the time it may take to finish a case. One possibility is to agree to a flat fee for each part of the matter. For example, you could agree to one amount through mediation, one amount through discovery and summary judgment, and a final amount for trial.

The contingency fee method is typically only used if you are suing someone else. In this situation, the lawyer agrees to take little to no money up front, but he gets a percentage of any recovery (after costs). This method isn't used often for start-ups, but in certain situations (patent prosecution, for example), it can be invaluable.

A new business can also pay their outside counsel in stock. This option can significantly strengthen the relationship between the lawyer and client, but it presents several difficulties for both.

First, there are professional responsibility issues for the lawyer. The lawyer has obligations of his own in this situation, but these obligations are also important from the point of view of the business because legal ethics requires that the transaction be fair and reasonable. Thus, time and money must be spent on a fair valuation of the equity.

Second, keep in mind that you are giving up a finite and valuable resource--ownership of your company.

Third, unlike hourly fees (which incentivize working on the file) or flat fee/contingency fees (which incentivize efficient work), paying periodically in stock may not incentivize the lawyer to work on your case quite as much, as the amount being paid may fluctuate. One way around this may be to agree to a payment of stock upon completion of the matter (much like a flat fee), but the longer the matters drag on, the more difficult valuation of the stock can be. The lawyer may also have SEC obligations that can trip up unwary counsel. Thus, while this option is certainly possible, and does happen, many lawyers are unwilling to take on the additional obligations and risk associated with this method.

Tax consequences

Professional services incurred in carrying on a trade or business, which are reasonable, ordinary and necessary, can be deductible. That means that the business could pay less income tax to the IRS, and could save money. For hourly or flat fees, the deductions would be deducted for the year in which they were incurred or the year they are paid (depending on the accounting method of the taxpayer). Thus, there can be a yearly tax advantage to hourly or flat fees.

There is a special deduction that can be used for the tax year in which the business was created called the start-up cost deduction. This can include surveying markets, product analysis, consulting fees paid in the course of getting the business ready to operate, or even state incorporation or legal fees. This deduction is capped however, and may only apply to businesses with relatively small start-up costs.

Conversely, there can be a tax advantage or consequence to the contingency fee method. For some limited types of cases, such as some personal injury cases, the entire recovery may be tax free. For other cases, including some employment cases, the recovery could be included in income (and thus require income taxes), but the attorney's fees could be deductible.

In some cases for certain size businesses, the fees you pay your lawyer under the contingency fee method may not be deductible. In fact, in those situations the entire recovery (including the part that you have to immediately pay to the lawyer) could be taxed as income. Thus, not only could you still have to pay your lawyer, but you may have to pay income taxes on the whole recovery.

Paying your lawyer with stock in the company, while potentially attractive, does not have the same tax benefits as paying with cash. Put simply, if you pay with cash, you most likely get a deduction. If you pay with equity, you don't. That means you lose the savings come tax season. Thus, while paying with stock can be tempting due to the fact that you don't have to put any cash aside, make sure to take the long-term into account, and research whether losing that deduction is actually worth it.

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Publication:Inside Counsel
Date:Mar 18, 2016
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