Life Insurance for Law Firms: Partner Buyouts and Key Person Cover

Short Answer: How Life Insurance Works at the Law Firm Level

Law firms use life insurance as a funding mechanism inside a larger plan. It can pay for a partner buyout required by the partnership or shareholder agreement, cushion the firm against losing a key attorney, and supply cash during a succession. The policy funds the plan. The agreement, the firm's ownership form and federal tax rules decide how it works.

This page is written for multi-partner firms planning at the entity level. It covers three uses: buy-sell funding, key person protection and succession continuity. In each, the federal tax treatment turns on who owns the policy, who pays the premiums and who is the beneficiary. The individual attorney-owner's share and solo-practice continuity are covered on the lawyers page.

Why Life Insurance Planning Matters for Law Firms

A law firm's value sits largely in people rather than in equipment or inventory. Firms are commonly organized as general partnerships, limited liability partnerships (LLPs) or professional corporations (PCs). That choice matters because several federal insurance rules turn on whether the parties are partners, shareholders or employees.

Partner capital accounts, client relationships and origination credit are often concentrated in a few individuals. Origination credit means the firm's internal credit for bringing in a client matter. When one partner holds much of that credit, the firm faces two linked problems at that partner's death. Revenue may fall, and an ownership interest has to change hands.

The partnership or shareholder agreement often makes the second problem a contractual one. A partner's death can trigger an obligation for the firm or the surviving partners to buy the deceased partner's interest from the estate. Without a funded plan, the surviving partners may pay out of pocket, borrow, or draw down firm assets at a difficult moment. Life insurance is one way to put cash where the agreement says it will be needed.

State bar and professional-licensing rules vary by state; this page covers federal tax rules only.

Key Risks Law Firms Face When a Partner Dies or Departs

Five risks recur in law firm planning.

• Buyout obligation risk. The firm or the surviving partners may owe the estate the value of the deceased partner's interest, sometimes on a fixed schedule.
• Key person revenue risk. The death of a rainmaker or practice-group leader can reduce billings, unsettle client relationships and strain the firm's ability to service debt.
• Succession risk. If no funded transition plan exists, a firm may lose value during the transition or dissolve.
• Valuation complexity. Law firm interests are often valued by a formula in the partnership or shareholder agreement. The formula may rely on capital accounts, a multiple of earnings or another method, and it may not match the face amount of any policy.
• Debt and lease obligations. A firm with a bank loan or a long office lease may carry fixed payments regardless of a partner's death.

Each of these risks becomes a number, and the number usually comes from the firm's agreement and its valuation method.

Who This Page Is For

The audience here is managing partners, equity partners, firm administrators and finance leads at multi-partner law firms. It is written for a firm that is evaluating a funded law firm buy sell agreement, a key person policy or a broader succession plan.

The rules described apply most directly to firms organized as general partnerships, LLPs or professional corporations, with the caveat that whether an LLP counts as a partnership under these particular rules is a question for the firm's advisers. Firm leaders who have not yet involved qualified tax, legal and insurance professionals commonly do so before any arrangement is structured. Sole practitioners and individual attorney-owners will find their questions on the lawyers page.

Key Person Considerations for Law Firms

Key person insurance for law firms is a policy the firm owns on a partner or key attorney whose death would cause measurable financial harm to the firm. The firm applies for the policy, pays the premiums and is named as beneficiary. The insured is the partner or employee. The proceeds belong to the firm and can be used to replace lost revenue, recruit a successor or meet fixed obligations.

Premium deductions come first. Section 264(a)(1) of the Internal Revenue Code provides that "No deduction shall be allowed for— (1) Premiums on any life insurance policy … if the taxpayer is directly or indirectly a beneficiary under the policy or contract." A firm that is the beneficiary of its own key person policy falls within that text.

The death benefit's treatment begins with Section 101(a)(1), which provides that "gross income does not include amounts received … under a life insurance contract, if such amounts are paid by reason of the death of the insured," subject to listed exceptions. The Treasury regulation at 26 C.F.R. § 1.101-1 implements the exclusion. Two exceptions matter here: the transfer-for-value rule of Section 101(a)(2), and the employer-owned contract rule of Section 101(j).

Under Section 101(j)(1), for an employer-owned life insurance contract, the exclusion "shall not exceed an amount equal to the sum of the premiums and other amounts paid by the policyholder for the contract." The cap is lifted only if two things are both true:

1. A Section 101(j)(2) exception applies. One is based on the insured's status, such as being an employee during the 12-month period before death or, when the contract is issued, a director or highly compensated employee. The other covers amounts paid to the insured's heirs or used to buy an equity interest from them.
2. The Section 101(j)(4) notice and consent requirements were met before the contract was issued. The employee is notified in writing of the intent to insure and the maximum face amount, gives written consent, including consent to coverage continuing after employment ends, and is informed in writing that the policyholder will be a beneficiary.

Neither condition is enough without the other.

Several answers in Notice 2009-48 address ownership and employee status. Under A-3, ownership "by a partnership or sole proprietorship does not prevent the contract from being treated as an employer-owned life insurance contract." Under A-5, "employee" includes "an officer, director, and highly compensated employee," and the notice explains that special rules for highly compensated employees can reach certain former employees and self-employed individuals. Under A-1, a contract "owned by the owner of an entity … (such as for purposes of financing the purchase of an equity interest of another owner)" is not an employer-owned contract. Notice 2009-48 A-13 also states that a failure to obtain written consent "cannot be corrected after the insured employee has died."

Section 6039I requires every applicable policyholder owning employer-owned contracts issued after the section's enactment to file an annual return and keep records showing, among other items, whether it holds a valid consent for each insured employee. Employer-owned life insurance notice and consent under Section 101(j), and the related annual reporting, need individual review by qualified tax, legal and insurance professionals.

Buy-Sell Considerations for Law Firm Partnerships

A buy-sell agreement is a contract that obligates the surviving owners, or the firm itself, to buy a deceased owner's interest at a set price or by a set formula. Life insurance funds the obligation. Law firm partner buyout insurance generally follows one of two structures.

• Cross-purchase. Each partner owns, pays for and is beneficiary of a policy on each other partner. At a death, the survivors collect the proceeds and buy the interest from the estate. Under Notice 2009-48 A-1, a policy owned by an owner to finance the purchase of another owner's interest is not an employer-owned contract. The number of policies grows quickly as partners are added.
• Entity purchase, or redemption. The firm owns one policy on each partner and uses the proceeds to buy the deceased partner's interest. Because Notice 2009-48 A-3 says partnership ownership does not prevent employer-owned treatment, the Section 101(j) analysis applies.

Transfers of existing policies raise a separate question. Section 101(a)(2) provides that, after a transfer for valuable consideration, the exclusion "shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee." The examples in 26 C.F.R. § 1.101-1(g) show how the limit works in practice. Section 101(a)(2)(B) lifts the limit if the transfer is "to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer."

The ownership form changes the analysis. In a partnership, a transfer to a co-partner is on the list. In a professional corporation, a co-shareholder is not on the list, although a transfer to the corporation itself is. On corporate redemption agreements, the Supreme Court in Connelly v. United States, a case about a closely held corporation, explained that "redemption obligations are not necessarily liabilities that reduce a corporation's value for purposes of the federal estate tax." The Court decided that one valuation question on its facts.

The Section 264(a)(1) rule applies in either structure. Whether the payer is the firm or a partner, premiums are not deductible when the payer is directly or indirectly a beneficiary. Business valuation for buy-sell funding, transfers of policies between owners, and an LLP's status under these rules need individual review by qualified tax, legal and insurance professionals.