Introduction

The departure of a partner from a law firm — whether through retirement, voluntary exit, or dissolution — raises a question that is surprisingly contentious in many firms: what is the departing partner's share of the firm's goodwill worth, and who pays for it?

The answer to this question has tax implications for both the departing partner and the firm, and the structure of the buyout determines the tax treatment of amounts received.

The Nature of Law Firm Goodwill

Goodwill in a law firm context represents the value of the practice beyond its tangible assets — the client relationships, the firm's reputation, the expected continuation of billings. In many service businesses, goodwill is a significant component of value. In law firms, the picture is more complex.

Personal goodwill — the value attributable to a specific lawyer's client relationships — may not transfer when that lawyer leaves. If clients follow the departing partner, the goodwill has no value to the remaining firm; it has value to the departing partner personally.

Institutional goodwill — the value attributable to the firm's brand, systems, and non-personal client relationships — may remain after a partner's departure. This is the goodwill that has value to the buyer (the remaining partners or successor firm).

Many law firm partnership agreements explicitly address goodwill — whether it is recognised for buyout purposes, how it is valued, and whether departing partners are entitled to any payment for it.

Tax Treatment of Goodwill in a Partner Buyout

For a departing partner who receives a payment attributable to goodwill, the tax treatment depends on what is being sold and the structure of the transaction.

Sale of partnership interest: If the departing partner sells their entire interest in the partnership, the gain is generally a capital gain — calculated as the proceeds minus the ACB of the partnership interest. Goodwill is subsumed within the overall partnership interest value.

Payments for personal goodwill: Where a payment is specifically identified as compensation for personal goodwill — the departing partner's client relationships — the CRA may characterise this as income (if it represents compensation for future referrals or services) rather than a capital gain. The characterisation requires careful analysis.

Restrictive covenants: Amounts paid to a departing partner in exchange for an agreement not to practise in a certain area (a non-compete covenant) are specifically addressed in section 56.4 of the Income Tax Act. Where an amount is paid for a restrictive covenant that is ancillary to the disposition of a partnership interest, it may be treated as part of the proceeds of disposition — a capital amount. Where it stands alone, it may be fully included in income. The characterisation of restrictive covenant payments is a specific area of CRA scrutiny.

Successor Partner Considerations

The partner or partners who pay for the departing partner's interest receive a stepped-up ACB in their partnership interest equal to the amount paid. For amounts allocated to goodwill in an asset-based buyout, the acquiring partner adds the cost of the goodwill to their Class 14.1 pool and amortises it at the applicable CCA rate.

The Unfunded Buyout Problem

Many law firm partnership agreements specify a goodwill formula but provide no funding mechanism for the buyout. A senior partner approaching retirement may have a contractual right to a significant payment for their share of firm goodwill — but the remaining partners must fund that payment from operating cash or external financing.

Unlike a corporation where life insurance can fund a buy-sell (with proceeds flowing through the capital dividend account), partnership buyouts are often funded from cash flow, creating a genuine liquidity challenge for smaller firms.

When to Speak With a CPA

The tax treatment of a law firm partner's departure — including the characterisation of goodwill payments, the calculation of capital gains, and the treatment of restrictive covenants — is specific and requires a CPA familiar with partnership tax. Planning the structure of a buyout before the partner gives notice produces significantly better tax outcomes than addressing it after.

Rotaru CPA works with lawyers and law firms on partner transition planning and the tax mechanics of partnership interests. Book a consultation to discuss an upcoming departure or succession.