Selling a Law Practice: How the Taxes Work for a Rule 1.17 Sale or a Partner Buyout

What the ethics rules allow you to sell

Before the ABA added Model Rule 1.17 in 1990, most states did not let a lawyer sell practice goodwill. Today nearly every state has adopted a version of ABA Model Rule 1.17, which lets a lawyer sell an entire practice, or an entire area of practice, to one or more lawyers or firms. The seller must stop practicing in that area in the jurisdiction or geographic area, clients must get written notice of the sale, of their right to take their files or hire other counsel, and that consent is presumed if they do not object within 90 days, and fees cannot go up because of the sale.

States vary. Ohio's version, for example, requires a confidentiality agreement before a prospective buyer sees client information, requires the buyer to honor existing fee agreements, and lets the sale agreement reasonably limit the seller's return to practice for a set time or area (Ohio Rules of Professional Conduct, Rule 1.17(c) to (e)). Check your own state's rule before you draft a term sheet, because the notice timeline drives your closing date and therefore your tax year.

The buyer pool is small, and that shapes the deal

Rule 5.4 keeps nonlawyers from owning law firms in most states, so your buyers are other lawyers. Arizona is the main exception: since 2021 its Supreme Court has licensed alternative business structures with nonlawyer owners (Arizona Judicial Branch, ABS program). A smaller buyer pool means less cash at closing. Most law practice sales are paid over time, often as a share of fees collected from transferred clients for a fixed number of years. That is a contingent payment installment sale, and with no stated maximum but a fixed period, basis is recovered evenly over the payout years under Treas. Reg. 15a.453-1(c)(3).

When the price is a percentage of fees, protect the payment stream: audit rights over the buyer's billing for your former clients, a UCC lien on the practice assets, a personal guarantee from the buying lawyer, and acceleration if the buyer sells or merges the practice. The contingent payment installment sale and seller financing pages cover the reporting and the protections.

Receivables, unbilled time and pending contingency cases

Most lawyers report on the cash method, so nothing billed or unbilled has been taxed yet. Whatever the buyer pays you for those rights is ordinary income, because fees for services are not capital assets (IRC 1221(a)(4)).

Pending contingent fee cases are the large, uncertain item in many plaintiff practices. Your right to part of a future fee on a case you worked is a right to payment for services already rendered, so it is ordinary income when you receive it, whether it arrives as a fee division with the buying lawyer or as a price adjustment. Write the split for each open case into the sale agreement, get the client consent your state's fee-division rule requires, and do not label case fees as goodwill. If the case settles three years later, that payment is still ordinary income in the year you are paid.

Retiring from a firm: why Section 736 decides your rate

Most lawyers who leave a partnership or a multi-member LLC are not selling to an outsider. The firm buys them out with payments over several years. Those payments fall under IRC 736, and a special rule applies to service partnerships. Under IRC 736(b)(2) and (3), when capital is not a material income-producing factor (true of nearly every law firm) and the retiring partner was a general partner, payments for the firm's unrealized receivables and for goodwill are treated as ordinary income to you and deductible to the firm, unless the partnership agreement provides for a payment for goodwill. Only then is the goodwill portion a distribution taxed as capital gain.

Under Treas. Reg. 1.736-1(b)(3) the agreement must provide for a reasonable goodwill payment, and a value the partners set at arm's length, as a fixed amount or a formula, is generally respected. Under IRC 761(c) the agreement includes amendments made up to the original due date of the firm's return for that year. Your partners have a reason to stay silent, since ordinary payments are deductible to them. Read the agreement now, years before retirement, not after you give notice.

Worked example: the same $1,000,000, three ways

A California solo who sells the whole practice for $1,000,000 cash, with $200,000 of it for unbilled time and pending fees, owes $252,288 of tax caused by the sale, an effective 25.2%. California taxes capital gains as ordinary income, with a top rate of 13.3% including the 1% surcharge over $1 million (FTB, 2026), so the state bite does not depend on the character of the income.

A retiring general partner paid the same $1,000,000 by the firm in four yearly installments owes $138,724 over the four years if the partnership agreement provides for a goodwill payment. If the agreement is silent, the identical payments are ordinary income under Section 736(a) and the tax rises to $210,136, or $71,412 more. The federal gap comes from ordinary rates up to 37% replacing the 0% and 15% capital gain brackets (Rev. Proc. 2025-32, 2026); the capital gains hub has the bracket table and the California page has the state detail.

Selling your interest to the other partners instead

A partner can also sell the interest to the remaining partners rather than have the firm liquidate it. That is a sale of a partnership interest under IRC 741: capital gain, except that the share of the firm's unrealized receivables, including unbilled work, is ordinary income under IRC 751(c), and that ordinary piece cannot be reported on the installment method. Liquidation and cross-purchase can produce different totals for the same economics, so the buyout form belongs in the negotiation.

Non-competes, personal goodwill and what does not apply

Rule 5.6 forbids most agreements that restrict a lawyer's right to practice, but its comment carves out restrictions included in a Rule 1.17 sale (Ohio Rule 5.6, Comment 3). Because the seller already has to stop practicing in the area sold, a large separate payment for a covenant adds little legal protection and converts capital gain into ordinary income. Keep it modest.

If you practice through a professional corporation taxed as a C corporation, the personal goodwill sale analysis applies: client loyalty that belongs to you, with no employment agreement or covenant tying it to the corporation, can be sold by you directly and taxed once. One tool that does not apply is the small business stock exclusion, because law is an excluded field under IRC 1202(e)(3)(A).

Get the Big Sale Tax Analysis to model your sale or buyout terms before you sign.

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