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For most law firms, negotiating a lease and building out space are important short-term processes that have a significant impact on the long-term profitability of the firm. A poorly negotiated lease can be the proverbial albatross that hampers the firm’s results for years; a well-negotiated lease can be a godsend. The firm wants the lowest effective cost for the desired quality and quantity of space, while the landlord wants to maximize the effective yield on the space. How each party negotiates to accomplish these goals is a complicated, sometimes psychological process. Most law firm leases are for a period ranging from five to 10 years, sometimes longer. Estimating the amount of space needed today and in the future is never scientific. Many firms lease a bit more space than they need, expecting to grow into it, with options to acquire additional space later. Some lease the right amount from the beginning, then through downsizing, attrition, or defection, find they have excess capacity. Naturally, both of these situations have an impact on cash flow and financial results. That’s why, before entering into a lease, firms need to carefully evaluate their strategic plans and prospects for substantial staffing increases or reductions during the lease period. HANDLING EXCESS SPACE Many firms that entered into leases only a few short years ago were planning for unprecedented growth. Since then, growth has slowed for most firms. What can be done with excess space? First, consider your situation. Is your space in high demand? If so, consider subletting it on a short-term basis. Law firms traditionally have very nice space, so little additional build-out is needed to attract a subtenant. You may need to put up a few walls and a door, but that’s not terribly expensive. Few firms can sublease on their own, so expect to pay a leasing commission. These commissions are typically amortized over the term of the lease. In some cases, a tenant with buyer representation may pay the commission if a certain amount of free rent is part of the deal. Don’t want to be in the real estate business? Talk to your landlord first. If you are in high-demand space, your landlord may be able to sublease for you (and make a profit), relieving you of any landlord headaches. Unfortunately, for most firms, there is not enough of a “premium” for landlords to voluntarily take back your space. Alternatively, consider a friendly subtenant. Substantial benefits may be associated with letting retired partners keep their offices. Do you have clients or referral sources whose services complement your practice areas? Consider setting up full- or part-time offices to keep them close to you — and thinking of you. Perhaps a charity you support could use some temporary space or a convenient place to hold meetings. There is a lot of goodwill to be gained by giving away the use of space. Some firms have tried to use excess space for employee-friendly uses such as emergency or full-time day care, exercise facilities, and the like. Clearly, these uses involve a different kind of risk, which may require additional insurance. Also, once you need the space again, taking away a benefit employees have come to expect can affect morale. A few firms have implemented a safeguard mechanism against excess space due to unplanned partner departures. Any partner who leaves to compete with the firm continues paying a “rental supplement,” “equalization payment,” or the like to the firm, to prevent remaining partners from being left holding the bag. Of course, this arrangement is negotiated before anyone considers a departure, but properly structured, it creates both a deterrent to departures and a financial safeguard for the remaining owners. Decisions regarding the quality, quantity, and use of your space are very important since they can influence your image to clients, your financial well-being in difficult times, and the efficiency of day-to-day operations. TAX BENEFITS TO CONSIDER Once you have resolved your quality and quantity space requirements, you still have financial and tax matters to resolve. Some terrific tax benefits are available to both parties during lease negotiations, but law firms frequently make distributions to partners, or pay bonuses to shareholders, based on taxable income. Potential reductions in taxable income arising from accelerated tax deductions may mean less cash in owners’ pockets unless compensation and distribution policies are adjusted. Because ownership interests vary each year, most firms strongly prefer that accounting and tax results match their economic ability to distribute annual cash flow to owners. What if you are negotiating a new lease right now? An allowance for leasehold improvements is a fairly standard lease concession. As a tenant, two things are important: who pays for the improvements and who owns them. Paying for them is usually the greater concern. It should be no surprise that, in all but extremely poor markets, the tenant pays for improvements — either outright or through increased rent. But paying for improvements by increasing the rent generally means larger tax deductions since rent is fully deductible. Let’s say you need $1 million worth of leasehold improvements. On a 10-year lease, the landlord will increase the stated rental rate so that over the 10-year period, he will be paid for the improvements plus an interest factor. This strategy can be attractive to law firms for two reasons. First, it reduces the upfront cash requirement of the new lease. Secondly, lease obligations are generally disclosed in a footnote to the financial statements rather than as a liability on the balance sheet. Paying for improvements over the term of the lease may free up other borrowing capacity for the firm. Or, let’s say the landlord gives you a $1 million allowance in cash. The cash would likely be taxable to the firm in the year of receipt. The firm would own its improvements and would depreciate them over their legislated useful lives — 39 years for real estate, 15 years for land improvements, and five or seven years for personal property. Keep in mind that income recognition can be avoided by meeting specific, detailed, technical requirements. A third alternative is to negotiate a period of free rent. Let’s say you get six months of free rent. The firm could set aside the cash that would have been used to make rental payments and use those funds instead to make improvements. This option addresses the issue of funding. Since no cash came from the landlord, there is no taxable income to recognize. However, there is also no deduction for rent, since none is paid during the free-rent period. In most cases, the party paying for the improvements owns them. This can easily be changed, however, by specific language in the lease. If the parties intend for the tenant to own the improvements, clearly state this in the lease. Depreciation deductions follow the ownership of the improvements. In recent years, cost segregation studies have been used to identify property that is depreciable over five, seven, or 15 years. To the extent that the firm owns improvements, you want to be able to depreciate them as quickly as possible, in most cases. An even bigger tax break became available for the calendar year 2001. The Job Creation and Worker Assistance Act legislated a 30 percent additional first-year (bonus) depreciation. Although many technical definitions and restrictions apply, most leasehold improvements will qualify if they were acquired after Sept. 11, 2001, and before Sept. 10, 2004, and placed in service before Sept. 11, 2005, in a building that has been in service more than three years. An example of the substantial upfront benefit available for five-year property is shown in the accompanying chart. Clearly, a tax-motivated firm will negotiate to own as much five- and seven-year property as possible, leaving the 15- and 39-year improvements to be owned by the landlord. Those who want more stable deductions will let the landlord have the tax benefits in exchange for a reduced rental rate. Again, if taxable income is decreased due to the bonus depreciation, and cash distributions to owners are affected, many firms will elect out of taking bonus depreciation. This is particularly true for those firms that have large swings in ownership from year to year. Law firms have much to consider in reviewing space needs. Planning for both growth and contraction while retaining flexibility serves most firms very well. Tax benefits can often make the difference between a good deal and an exceptional deal. Valerie C. Robbins, CPA, is a partner in the Washington-based CPA firm of Beers & Cutler PLLC, where she works in the Law Firm Services Group. She can be reached at [email protected]or (703) 637-7590.

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