Nothing personal: leave the loan alone

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Published on 4/16/07

A new and growing law firm often seeks a bank loan when cash needs exceed cash-generation ability through client receipts and partner capital.

An unexpected tax liability, a new equipment purchase, unanticipated operating expenses -- any of these can require an immediate cash infusion to offset them. In such instances, lawyers typically use a line of credit through a bank where they have established a strong working relationship.

The lawyer borrows and repays at will up to the amount of the credit line, which is reviewed annually and extended, increased or terminated as circumstances warrant. The cost of such loans varies with factors such as your bank balance, other services purchased and credit rating.

No matter how fast the firm is growing, it is never a good idea to pay staff payroll using a bank loan. If you borrow for payroll and payroll-tax funds in anticipation of collecting on accounts receivable and then fail to collect enough to cover payroll and taxes sufficiently, the result will be civil and potential criminal penalties.

However, sole proprietors often consider drawing from a line of credit to pay themselves for the month. Their rationale is that they are not going to go too deeply into debt for such a purpose and they have cash that's due in at any time. What's wrong with using a credit line to pay yourself first?

Actually, there is no IRS problem with doing this. The only question pertains to the rationale on which the line of credit was provided.

This is a contract issue between you and your bank. However, using a bank line of credit to pay yourself is just as risky as using it to meet the firm payroll, and for the same reason. Too often the anticipated payment or new work doesn't materialize, and then you have a major problem with the lender.

The time to plan for paying your proprietorship "draw" is really well before you even enter practice.

I advise establishing a personal/professional expense hierarchy with these levels: practice needs, personal needs, savings for slow periods or emergencies, and "gravy" -- a potential personal bonus after all other expenditure needs are met.

Practice needs should always be met first, and personal needs should be the most flexible category. Personal needs, as covered by the lawyer's "draw," should be the minimum expense necessary for you and your family to maintain your standard of living.

If the practice produces sufficient income to increase your standard of living, fine. But the better approach is to avoid committing yourself to extensive obligations that you cannot reduce when necessary.

The conservative rule of thumb is for any new practice to have an adequate cash reserve covering a minimum six months of living expenses if no draws or salaries can be taken out of the firm.

Use savings, not a line of credit, to pay yourself. Otherwise, short-term borrowing can mean a short-term lifespan for your new firm.

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