Tax Distributions for Professional Firm Profits

Assessing the risk: allocation of profits within professional firms

On 1 March 2021, the ATO released Draft Practical Compliance Guideline PCG 2021/D2 Allocation of professional firm profits – ATO compliance approach (Draft PCG). The Draft PCG concerns arrangements involving individual professional practitioners (IPPs) who redirect their income to an associated entity from a business or activity which includes their professional services and has the effect of altering their tax liability.

After more than three years, and much anticipation, the Draft PCG explains the Commissioner’s risk-based compliance approach and outlines the ATO’s risk assessment process to determine if a Principal’s distribution profits from the firm is at risk of further ATO compliance review. When the Draft PCG is finalised (expected to be in November 2021), every Principal must review, assess and document their distribution policy as it applies from 1 July 2021.

The revised guidance:

    • outlines risk factors for when the ATO considers a distribution to be low, moderate, and high risk;
    • sets out a risk assessment framework when considering the allocation of profits within professional service firms (PSF); and
    • stipulates the ATO’s expectation for PSFs to review and assess their eligibility to apply the guidelines on an annual basis.


A Guide to:

Tax Distributions for Professional Firm Profits

As The Lawyer’s Accountants, FWO Chartered Accountants have prepared a white paper to:

    • summarise and step through key concepts in the Draft PCG,
    • unpack the main issues and considerations for Principals, and
    • discuss what actions professional firms must take.

This simple and easy-to-read guide helps ensure you are crystal clear in your understanding of the the new rules.

Warning: Ignore Your Profit Distributions Arrangements at your own risk

Download your free copy here


On-Demand Webinar:

Tax Distributions for Professional Firm Profits

In a recent webinar, Matt Schlyder, The Lawyer’s Accountant, summarised key concepts and presented a general overview to Law Firm Principals to help create awareness on these upcoming changes.

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FWO Chartered Accountants are the Lawyer’s Accountants. We specialise in providing tax advice and assistance to lawyers and Law Firms. Once the guidelines are finalised, we will be commencing reviews of Law Firm’s current arrangements under these guidelines to provide compliance advice and advise on any changes that are recommended to comply, including documentation to support any ATO enquiry into these arrangements.

The Most Important KPI for your Law Firm’s Profit Growth

Key Performance Indicators (KPIs) are much more than just information. They measure the key revenue and cash flow activities of a law firm to ensure its performance.

Not enough firms understand the importance of measuring and taking action to improve the fundamental KPIs around production management, in order to improve margin.

The core production KPIs are:

    • File Velocity Days
    • Average Rate
    • Productivity
    • Write-on (off)

Two high-level KPIs that firms need to focus on to drive overall performance are Average Rate and Lock-up Percentage.

Focusing on these Two Numbers gives you a framework to drive improvement in profit and cash flow. Average Rate directly correlates to driving profitability, while Lock-up Percentage focuses on improving cash flow.

This article deals specifically with Average Rate.


What is Average Rate?

When we refer to ‘Average Rate’, we are NOT discussing an average of fee earner charge-out rates. Average Rate is the calculation of revenue billed over professional employee labour paid.

This figure represents the average amount of revenue earned, for every hour your fee earners (including principals) are paid to work.

Average Rate = Revenue / Paid hours of direct labour

This KPI can measure the performance of individuals, teams, departments, and the business as a whole. Average Rate measures performance by incorporating productivity, write-offs, and recoverability over direct labour costs. As this number increases, so does businesses profitability (margin).

Average Rate is the most important KPI in terms of profit when it comes time to review your practice.

Need help understanding how to measure and track your Average Rate? Watch the following video (4:55) to see exactly how Average Rate is calculated.

The Factory

Your efficiency has a major bearing on your Average Rate. For a legal firm, efficiency can be described as the ratio between revenue and the direct labour cost to produce that revenue.

The ultimate financial measure for an efficient practice is gross profit, and the higher your Average Rate, the greater your gross profit. To improve gross profit from an efficiency perspective, you must ensure you carry the right amount of labour.

To determine the right amount of labour for your needs, you must have a “capacity management plan”. The starting point is to determine the Efficiency Factor for each team and department and the business as a whole.

Key Activities

Below are some of the key activities you can take that will drive improvement in Average Rate:

      1. Manage file velocity daily and weekly. The shorter the period a file is in the office, the better the recoverability of hours charged
      2. Bill everything in WIP, no write-offs
      3. Always remind the client of the value in the solution you provide to them
      4. Define your core products / service offerings and set minimum prices for them firm-wide
      5. Increase your charge rates across the board
      6. Set a minimum Average Rate per hour for the entire firm and bill to achieve this rate

When was the last time you reviewed your practice in respect of these activities? Not sure where to start? Let us guide you.


    • If your price increases exceed perceived client value, clients will eventually leave.
    • Be wary of the impact that your production systems have on client experience in the changes that you make. Client experience is just as valuable as the advice.

Key Takeaways

Challenge what is possible within your business. From a production perspective, Average Rate will provide you with the KPI to use to monitor your progress.

Key takeaways:

    • Average Rate tells us ‘What have we billed for every hour of labour we have paid for?’
    • Gross Profit = Revenue minus direct cost to generate revenue (including fee earner labour)
    • The key to profit is leverage: The number of fee earners per equity principal and the ratio of revenue earned per fee earner to their labour cost
    • Efficiency can be described as the ratio between revenue and the direct labour cost to produce that revenue
    • Warning: Numbers don’t lie but they can tell you the wrong story if you don’t read them correctly

If you are struggling to identify which KPIs are important for your business, more importantly if collecting said data in its complete form is also an issue, start tracking your Average Rate. This KPI will set your professional business on the right track.

Not sure where to start? Let us help guide you.

On-Demand Webinar:

The Most Important KPI for your Law Firm’s Profit Growth – Average Rate

Interested to learn more? Watch our recorded webinar to further drill down on how Average Rate can set the foundations for your firm’s profit growth. .

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    Ensure Your Firm’s Survival

    For a professional services firm to survive in uncertain times – including but not limited to pandemics – they must understand and critically evaluate these important questions:  

        1. What expenses are fixed and what are tied to revenue generating activities
        2. What return are you getting on the expenses directly tied to revenue generating activities?  
        3. How efficient are you at producing the work you are currently undertaking?  
        4. What is your firm’s average break-even point (BEP) per month?  
        5. If under the BEP, then what is the firm’s cash burn rate until they cross over the break-even point?  
        6. Does your firm have partner and operational alignment?


    1. What expenses are fixed and what are tied to revenue generating activities?

    The cost structures of your firm are fundamental to its longevity. Understanding the link and interrelationships between generating more revenue and the additional costs required (or the opposite), cost allocations, and fixed or marginal costs has significant impact on profitability.

    Understanding costs

    Understanding costs ensures your business is spending in the right areas, as costs are not only tied to profits of a stable business, but they’re also linked to generating revenue to grow or maintain current levels.

    One of the biggest mistakes even accountants make is incorrectly allocating fixed direct and indirect costs to review a ‘true’ reflection of the business and provide meaning.

    Total costs = Fixed costs + Variable costs

    Fixed costs

    When people think of costs they generally lean towards fixed costs, which are predominately tied to labour and the majority of your overhead expenses. Fixed costs are fixed for a known period of time and can only be broken with notice.

    Variable costs

    These are costs that increase or decrease with usage or volume of activities. The majority of variable costs are related to costs such as sales and marketing activities, direct costs (including labour or contractors), utilities or commissions.

    Costs allocations

    You will need to consider costs allocations in your business, especially at internal reporting levels. This will help identify profitability by team/business units, service/product lines and even the success of projects. To have effective costs allocations, first you need to identify the nature of costs and how they are assigned to each area of your business.

    Potential consequences

    Fixed costs Decrease


    • Decreasing fixed costs can lead to greater profitability if sales remain unchanged or if gross profit drops by less than the decline in fixed costs
    • Risk if those costs are needed to generate revenue
    • Increasing fixed costs can lead to greater profitability if sales increase through better service delivery by an amount which is sufficient to compensate for the increase in fixed costs
    • Risk if new revenue isn’t generated
    Variable costs Decrease
    • Decreasing variable costs can be effective if the product or service quality is retained
    • Risk if the service/quality levels drop and has consequential effect on sales
    • Improvement in product or service quality involves increasing variable costs but allows a higher price to be charged. This can improve profits if the price increase is both accepted by the market and sufficient to offset the higher variable cost
    • Risk if the service or product cost increase is less than increase in revenue


    2. What return are you getting on the expenses directly tied to revenue generating activities?

    Once you have broken down your firm’s costs structure, your direct costs and revenue generated will need to be assessed and analysed. This will include the productivity/efficiency of your professional employees, but more importantly, your marketing and sales activity spends.


    3. How efficient are you at producing the work you are currently undertaking?

    For professional businesses, efficiency can be described as the ratio between revenue and the direct labour cost to produce service-related revenue. How efficient your work force can finalise client work (job), including write offs, is directly tied to capacity management and costs to produce your average revenue per job.

    By understanding the break down in efficiency, you can improve your direct costs, and even repurpose these costs savings to the right revenue generating activities.

    Determining your efficiency factor

    ‘Efficiency factor’ is calculated by dividing revenue by capacity available. The efficiency factor KPI is extremely important as it indicates:

    • which area of your business needs attention to increase profitability; and
    • whether you have capacity for growth; or
    • if you are carrying too much labour.

    Read more here: Understanding your Efficiency Factor

    Efficiency factor = Actual Revenue ÷ Capacity


    4. What is your firm’s average break-even point (BEP) per month?

    Once you understand the difference between your direct, indirect, variable, and fixed costs at a minimum, you can then determine what your average break-even point per month is to hit as a non-negotiable for the firm’s survival. Be careful – firms often make the mistake of assessing a lower cost month verse the current average cost spend.

    Break-even point = Fixed Costs ÷ Contribution Margin


    5. If under the BEP, then what is the firm’s cash burn rate until they cross over the break-even point?

    For most firms running at below cost turnover figures, it is even more critical to understand the firm’s cash burn rate (i.e. how fast you are losing money and at what pace). Once you understand this, then you will have an idea how much money it will take to get back on track. You can plan in advance for your firm’s survival.

    Calculating cash burn rate

        1. Select a relevant period for calculation (usually the current and last two months)
        2. Normalise these amounts for any expected seasonality (i.e. holiday wind up or down)
        3. Find the difference between the starting and ending cash balance for the selected period
        4. Divide the total by the number of months in the selected period
        5. This is your current cash burn rate. Compare to a calculation of the previous period(s) to determine a negative or positive trend. This will be better visualised via a graph for ease of understanding.


    6. Does your firm have partner and operational alignment?

    Partner alignment is when all partners are aligned to the business strategy, not necessarily to each other personally. Personal outcomes will drive behaviours in a business context.

    When a firm is trying to survive, this alignment is more important than ever.

    If you have decision makers making inconsistent decisions, your cost of doing business increases. The firm will also start to decrease its efficiencies (productivity), adding further costs above what costs are predicted to increase.

    You will also send mixed messages to your employees who will need to help the firm survive. This is dangerous and can lead to poor culture and employment turnover.

    The first step to building a successful partnership is to get REAL with each other on what your personal goals and objectives are. Once this is out in the open, you can focus on setting an agreed business strategy that is achievable.

    The business will have standard systems and processes that we must all adhere to for consistency, efficiency, and quality assurance. But each partner must still be able to produce their results using the resources of the firm, each team may have a slightly tailored approach depending on their skillsets and industry specialty.

    Your firm must have a purpose other than money as to why it exists, but remember if the firm isn’t profitable, then it won’t survive. If you think of the firm’s purpose as the body, then profit and cash are the oxygen and blood that keeps it going.

    A strong, focused, and aligned partnership, working towards a common goal, will endure and produce amazing results.


    On-Demand Webinar: Ensure Your Firm’s Survival

    Interested to learn more? Watch our recorded webinar to further drill down on the implications for your firm. This webinar looks at how today’s response can position your business to thrive tomorrow.

    Watch Webinar

    Our webinars are an opportunity to tap into our knowledge and challenge your thinking.