Don't let a credit line become a noose

I have warned about the dangers of law firms paying staff salaries and even partnership draws by using their bank lines of credit.

In a credit line arrangement, the firm borrows and repays at will up to the amount of the credit line, which the bank regularly reviews and extends, increases or terminates as circumstances warrant. Such a practice seems simply too risky.

If you borrow for payrolls, partner draws and tax payments in anticipation of collecting on accounts receivable, and then fail to collect enough to cover the borrowing sufficiently, the result will be a damaged credit rating, not to mention potential civil and criminal penalties.

It should be said that there is no IRS problem with using credit line withdrawals for such purposes. 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, in today's difficult credit market, when banks are even unwilling to lend overnight to other banks, lines of credit are in danger of tightening or even drying up entirely. The simple fact is that banks need to be assured that they are going to be repaid or they won't loan money.

When even large law firms like Heller Ehrman and Thelen Reid run into financial and economic difficulty in today's market, banks are going to be much more cautious in extending credit to any law firm customer - especially one that views a line of credit as a blank check to use at will.

This kind of borrowing is especially an issue at year-end for many law firms, large and small. It is created by accountants' tax advice to clear out a firm's cash before Dec. 31 of each year.

The problem for many attorneys is that this leaves them little or no reserve to make capital improvements, expand their office or increase the number of attorneys/staff to meet new client needs/demands, let alone normal operating needs.

It would seem that law firms should be able to find a way to accumulate capital, with minimal tax consequences, in order to fund their needs in a down economy without resorting to a credit line.

But lawyers generally don't think this way.

A number of years ago, the accounting industry seemed poised to make big inroads into the legal sector - until Enron hit. One reason accounting firms were confident they would succeed was because they could create a capital fund, while lawyers (with a shorter-term vision) always took everything they could from the cash register.

That's the real issue with using a credit line to pay partnership draws as well as payrolls. Equity partners don't receive payroll, they receive what's left over (the profits). Too many equity partners think as employees who are entitled to a paycheck, rather than as owners.

In a down economy, firms will have to "knock on wood" and hope for quick collection of accounts receivable when they begin the year by having little cash on hand. Borrowing to meet immediate needs and hoping the receivables do come in like they have before is even more risky today.

At a time when even large law firms run into financial and economic difficulty, banks become reluctant to give credit to any law firm customer, especially ones that view a line of credit as a blank check to tide them over for normal operations.