How a Law Practice Sale Is Taxed | Kathryn Meyer Law PC

When a law practice's assets are sold, the IRS treats it as a sale of each asset, not one sale of a business. Buyer and seller split the price among seven asset classes under IRC 1060, and each slice is taxed on its own terms: receivables and depreciation recapture produce ordinary income, while goodwill the seller built is generally a capital asset. Both sides report the split on Form 8594, and in California, Rule 1.17 sets the ethical conditions for selling a practice's goodwill.

The allocation is negotiated, so the tax result is decided at the bargaining table, not at filing time. Planning an exit is part of Kathryn Meyer's work on tax planning for law firms.

How the sale of a law practice is taxed, step by step

Decide what is being sold. A buyer can purchase the practice's assets, the stock of a law corporation or an interest in a partnership. IRS Publication 544 says stock usually produces capital gain or loss, and a partnership interest is a capital asset except for the part of the gain from unrealized receivables or inventory, which is ordinary.
Confirm the ethics conditions. California Rule of Professional Conduct 1.17 allows all or substantially all of a law practice, including goodwill, to be sold to another lawyer or law firm, but only on its conditions, covered below.
Agree on the price allocation. For an asset sale, IRC 1060(a) requires the price to be allocated among the assets under the residual method. If buyer and seller agree in writing on the allocation or on the value of any asset, the agreement binds both of them unless the IRS finds it not appropriate.
Work out the tax on each class. Gain or loss on each asset is figured separately; Publication 544 says capital assets produce capital gain or loss, business property held more than a year produces section 1231 gain or loss, and some gain is recaptured as ordinary income.
File Form 8594. The Form 8594 instructions say that generally both buyer and seller must file it with their income tax returns for the year of the sale when a group of assets that makes up a trade or business changes hands and the buyer's basis is set by what it paid.
Report later changes. If the price rises or falls in a later year, for example under an earnout, the affected party files a new Form 8594 with a supplemental statement for that year.

The seven asset classes in a law practice sale

The residual method fills the classes in order. The amount allocated to any asset other than Class VII cannot exceed its fair market value, and whatever is left goes to goodwill and going concern value.

Class	What it covers (Form 8594 instructions)	Typical law practice items	Seller's tax character	Buyer's treatment
I	Cash and general deposit accounts	Operating account balances (client trust funds belong to clients)	No gain	Basis equals the cash
II	Actively traded property, certificates of deposit, foreign currency	Rare in a practice	Capital or ordinary by asset	Cost basis
III	Debt instruments, including accounts receivable	Billed but unpaid fees	Ordinary; receivables for services are not capital assets (IRC 1221(a)(4))	Cost basis, collected as received
IV	Inventory and property held for sale to customers	Usually none	Ordinary	Cost basis
V	All other assets, such as furniture, fixtures and equipment	Computers, furniture, office equipment	Gain up to prior depreciation is ordinary (IRC 1245); the rest is section 1231 gain if held over a year	Depreciates its cost
VI	Section 197 intangibles other than goodwill and going concern value	Client lists and files, a covenant not to compete, workforce in place, a trade name	Depends on the asset	Amortizes over 15 years (IRC 197(a))
VII	Goodwill and going concern value	The practice's reputation and referral base	Self-created goodwill is generally a capital asset	Amortizes over 15 years (IRC 197(a))

On goodwill: the seller cannot amortize goodwill it created itself (IRC 197(c)(2)), and goodwill is not on IRC 1221(a)'s list of property excluded from capital assets, so the seller's built-up goodwill is generally a capital asset. Whether that goodwill belongs to the lawyer personally or to the firm's entity is a question to settle before the agreement is signed, because it decides who reports the gain.

What California's Rule 1.17 requires

The whole practice. The sale must be of all or substantially all of the practice; the rule's comment says this bars selling only a field of practice or a geographic part, and the purchaser must take on all client matters sold, subject to client consent and conflicts.
No fee increase because of the sale. Fees charged to clients cannot be increased solely by reason of the sale, and the comment says the purchaser must honor existing fee and scope arrangements.
Written notice and consent. For a living seller, written notice goes to each client at least 90 days before the transfer, telling the client of the transfer, the right to retain other counsel and the right to take the client's materials; the seller must obtain the client's written consent, which is presumed after 90 days if reasonable efforts to locate the client draw no response.
Conflicts and confidentiality. The purchaser must comply with Rules 1.7 and 1.9, and confidential information may not be disclosed to a nonlawyer in connection with the sale.
What the rule does not cover. Joining or retiring from a firm, retirement plans and a sale of only the practice's tangible assets fall outside Rule 1.17.

The 90-day notice period affects the tax calendar too: a sale planned for late in the year may close in the next tax year, which moves the gain and the Form 8594 filing into that year.

What changes the answer

Asset sale or entity sale. Publication 544 treats stock and partnership interests differently from a sale of assets, and the Form 8594 instructions say a transfer of a partnership interest generally does not require Form 8594 unless it is treated as a purchase of partnership assets.
The firm's entity. A C corporation that sells its assets recognizes the gain itself (Publication 544), so the owners can face a second tax when the proceeds come out; S corporations and partnerships pass gain through. See which entity a California law firm can use and how it is taxed.
How the price is split. Under IRC 1060(a), a written allocation binds both sides; money moved from goodwill to receivables or equipment generally turns capital gain into ordinary income for the seller.
The covenant not to compete. For the buyer, a covenant entered into with the acquisition is a section 197 intangible amortized over 15 years, and it cannot be treated as disposed of before the buyer disposes of its entire interest in the business (IRC 197(f)(1)). The seller should settle the tax character of any covenant payment with an adviser before signing, because it is a payment for the seller's own promise rather than for goodwill.
Contingent payments. The Form 8594 instructions require the maximum consideration to be stated, assuming all contingencies are met, and a supplemental statement for each later year the price changes.
The wider deal. Many questions are the same as in any business sale; see what tax questions to settle before selling a business.

For example: a solo practice sold for $500,000

For example, a California solo lawyer operating as a sole proprietor sells all of her practice to another firm for $500,000, after giving each client the 90-day written notice Rule 1.17 requires. The parties agree in writing to allocate $50,000 to billed receivables (Class III), $30,000 to equipment (Class V), $20,000 to a covenant not to compete (Class VI) and $400,000 to goodwill (Class VII). Assume the receivables have no basis because the firm uses the cash method and has not yet reported those fees, so the $50,000 is ordinary income. The equipment cost $30,000 and was fully depreciated except for $5,000 of basis, so her $25,000 gain on it is ordinary income under IRC 1245. Her $400,000 for goodwill she built is generally capital gain. The buyer amortizes the goodwill at $26,667 and the covenant at $1,333 for each full year of the 15-year period. Both attach Form 8594 showing $500,000 of total consideration to their returns for the year of the sale. This is a hypothetical, not a real case.

Common mistakes when selling a law practice

Leaving the allocation to the closing documents' last draft. Under IRC 1060(a) the written allocation binds both parties, so it should be negotiated with the tax result in view.
Selling one practice area. Rule 1.17 permits a sale of all or substantially all of a practice; selling only a field or a geographic part is barred.
Raising fees to pay for the purchase. Rule 1.17 bars increasing fees solely because of the sale.
Mismatched Forms 8594. Buyer and seller each file; inconsistent numbers invite questions.
Forgetting the supplemental Form 8594. An earnout or price adjustment in a later year needs its own filing.
Treating client trust funds as sale proceeds. Rule 1.15 funds are held for the benefit of clients, not owned by the seller; see who pays tax on interest earned in a lawyer's trust account.

What to do this week

Decide whether you are selling assets, stock or a partnership interest, and confirm the firm's entity and its standing with the state. The Annual Tax Health Checkup includes an entity status check with your state.
List the practice's assets by Form 8594 class, with cost, depreciation taken and current value.
Total billed receivables and unbilled work, and confirm the firm's accounting method.
Draft the Rule 1.17 client notice and set the transfer date at least 90 days later.
Model the tax on two or three allocations before agreeing to one in writing.
Plan for the tax due on the gain in the year of sale, including quarterly estimated taxes.

Frequently asked questions

Can a California lawyer sell goodwill at all?

Yes. Rule 1.17 allows all or substantially all of a law practice, "including goodwill," to be sold to another lawyer or law firm, subject to the rule's conditions.

Does the buyer have to file Form 8594 too?

Yes. The instructions say that generally both the purchaser and the seller must file Form 8594 with their income tax returns for the year of the sale.

Can the buyer deduct what it pays for goodwill?

Not all at once. Goodwill acquired in the purchase is a section 197 intangible, amortized ratably over 15 years beginning with the month it was acquired (IRC 197(a)).

What if the price depends on future collections?

The Form 8594 instructions require the maximum possible consideration to be stated, and a supplemental Form 8594 for each later year in which the price increases or decreases.

Can a broker who is not a lawyer be paid for arranging the sale?

The Rule 1.17 comment says payment of a fee to a nonlawyer broker is governed by Rule 5.4(a), so that rule must be checked before agreeing to any broker fee.

What about expenses of winding down the practice?

Ordinary costs of running the practice up to the sale remain business expenses; see which law firm expenses are deductible.

Does it matter if my law corporation is suspended?

Yes. A suspended corporation cannot legally do business or sell real property until revived; see what happens if California suspends your law corporation.

Planning the sale before you sign

The tax result of a practice sale is mostly set by the purchase agreement. Kathryn Meyer spent more than two decades in the IRS Office of Chief Counsel and helps lawyers think through allocation, reporting and timing before a deal is final, as part of her strategic tax counsel work. To plan your exit, contact the firm or call (571) 560-8674.

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