PRESERVING THE PRACTICE: ESTATE PLANNING PITFALLS FOR OWNERS OF A PROFESSIONAL SERVICES FIRM

By: Aaron T. Troy, Esq. and David F. Rolewick, Esq
Rolewick & Gutzke, P.C., Wheaton, Illinois
© 2005

Most professionals who own their own practice (such as doctors, dentists, lawyers, architects, engineers, veterinarians, and accountants) likely have an estate plan in place to provide for their family after their death. However, when a professional is the sole shareholder, officer, director, member, or manager of their practice at death, the business may be in danger of dissolution and may not be able to enforce certain contracts, such as its key employees’ covenants not to compete. Without taking adequate precautions, both pre- and post-death, a substantial asset to be passed on to the professional’s family – the value of the practice – is in danger of significant dissipation.

General Business Organization Laws

If the practice is formed as an Illinois Limited Liability Company, certain provisions of the Limited Liability Company Act (1) (“LLC Act”) may lead to the dissolution of the practice. An individual member of an LLC is dissociated from the entity upon his or her death. (2) Upon the death of the last remaining member, the representative of his or her estate can, within six months, elect in writing to continue the business until a new member is admitted to the company. (3) The articles of organization can provide for a time period longer than six months for the representative to elect to continue the business. (4)

The LLC Act does not specify what would happen in the event the personal representative fails to make an election within the six month period; however, without any living members, it would seem the entity would be treated as dissolved.

The owners of a professional LLC likely could not use the operating agreement to “opt out” of these provisions of the LLC Act. Section 15-5 of the LLC Act provides that the operating agreement cannot “vary the requirement to wind up the limited liability company's business in a case specified in subdivision[] (3)...of Section 35-1.” (5) Section 35-1(3) provides that an LLC must be dissolved and its business wound up upon the occurrence of “[a]n event that makes it unlawful for all or substantially all of the business of the company to be continued, but any cure of illegality within 90 days after notice to the company of the event is effective retroactively to the date of the event[.]” (6) As will be discussed in greater detail below, the death of the sole member or manager of a professional LLC will likely make it unlawful to carry on the practice under the laws governing that particular profession. Thus, the end result is that the LLC’s operating agreement cannot be used to avoid the problems associated with the death of the sole member or manager.

If the practice is organized as a Professional Corporation, the Illinois Professional Service Corporation Act (7) (“PC Act”) requires that all holders of the capital stock of the entity be individuals who are duly licensed or otherwise legally authorized to render the specific professional services as those for which the corporation was organized. (8) The PC Act further requires that the articles of incorporation provide for the purchase or redemption of the shares of any shareholder upon his or her death. (9) Unlike the LLC Act, the PC Act does not provide a cure period or other temporary period for the last shareholder’s estate to continue the business.

Specific Professions and Occupations

In addition to the LLC Act and the PC Act, professionals need to be aware of the laws governing their particular profession. Such statutes may impose restrictions upon who may own an interest in their practice. The following are just a few examples of Illinois statutes for various professions:

  • Physicians: All officers, directors, and shareholders of a medical corporation authorized to provide medical services must, at all times, be individuals licensed pursuant to the Illinois Medical Practice Act of 1987. (10)
  • Dentists: The Illinois Dental Practice Act allows the personal representative of a deceased dentist’s estate to continue their practice, but only if the personal representative: (1) contracts with another licensed dentist to run the practice; (2) sends a valid notice of the death of the original dentist to the Illinois Department of Professional Regulation; and (3) sends notice, within 30 days, to each patient who had seen the deceased dentist in the previous 12 months. (11) Even if all these requirements are met, the practice can only be continued for a period of 12 months or until it is sold, whichever occurs first. (12)
  • Architects: At least two-thirds of the directors, general partners, or members of an architectural firm must be licensed to practice one of the following disciplines: architecture, professional engineering, land surveying, or structural engineering. (13) Additionally, an architectural firm must have at least one managing agent who is licensed to practice under the Illinois Architecture Practice Act of 1989. (14)
  • Professional Engineers: Any professional design or engineering firm must have at least one managing agent who at all times maintains a valid, active license to practice professional engineering in Illinois. (15) Upon the death of a managing agent, the firm must notify the Department of Financial and Professional Regulation in writing within 10 days and, if it fails to do so, the firm’s registration is terminated immediately without a prior hearing. (16)
  • Accountants: In order for an accounting firm to be licensed to practice public accounting in Illinois: (1) a majority of the firm’s ownership interests must belong to individuals licensed in some state; and (2) all partners, officers, shareholders, members, or managers whose principal place of business is in Illinois and who practice public accounting in Illinois must be licensed in Illinois.17 Any firm that practices, offers to practice, or holds itself out as practicing as a licensed public accounting firm without a valid license is subject to civil penalties. (18)

Thus, a significant issue arises when the sole or last surviving owner of a professional practice dies. Presumably, the professional’s estate plan will have left his ownership interest in the practice to his spouse, children, or other immediate family members. However, if the ownership interest passes pursuant to a will or trust agreement, for a period of time it will be held by his or her estate or trust, which is not an “individual” as that term is used in any of the aforementioned statutes, and which cannot obtain the required licenses to be a valid owner of the business.

The same problem can arise through an inter vivos transfer by the owner of his ownership interest to a self-declaration of trust. It is not uncommon for an estate planner to recommend to his or her professional clients to place their business into a trust. A trust, however, is likewise not an “individual” nor is able to obtain the required licenses to legally own a professional practice. In light of these statutes and the cases discussed below, it may be unwise for an estate planner to advise his or her client to transfer ownership of the client’s professional practice to a trust.

If the professional’s spouse or children are not licensed to carry on the professional practice, they will ultimately seek to sell the interest to someone who is licensed. However, in the interim period, while the decedent’s estate or trust is being administered and a suitable purchaser for the business is sought, the practice will be in a dangerous purgatory in which it may not be recognized as a valid entity. The most severe consequence of this limbo is that the practice may not be able to enforce its noncompete covenants with its key employees, or enjoy the benefits of other contracts. As a result, the practice could lose most or all of its value before a purchaser can even be found.

Parvaiz and Dettman: Unenforceability of Covenants not to Compete

In Virenda S. Bisla, Ltd. v. Parvaiz, (19) a medical corporation filed for a preliminary injunction, seeking to prevent one of its physicians from practicing medicine in violation of his covenant not to compete. In 1998, the physician entered into an employment agreement with the practice to work as a cardiologist. The employment agreement contained a covenant not to compete within 10 miles of the practice for a period of one year after the termination of the agreement. The employment agreement also contained a provision stating that, in the event of the dissolution of the practice, the employment agreement would be automatically terminated. In December 2002, the Illinois Secretary of State involuntarily dissolved the practice for failing to pay its annual fees. The practice applied for and was granted reinstatement in July 2003, retroactive to the date of involuntary dissolution. Later, the cardiologist had a series of disagreements with the owner of the practice and began practicing medicine elsewhere, arguing that his employment agreement and covenant not to compete had been terminated upon the dissolution of the practice. The First District of the Illinois Appellate Court noted that generally, “a professional’s interest in his or her medical practice is a protectable business interest.”20 However, the question in this case hinged upon whether the employment agreement and covenant not to compete were valid and in force at the time the physician pursued his other employment opportunities. In ruling that the covenant not to compete was invalid, the court stated that the employment agreement made clear that the dissolution of the practice automatically terminated the agreement. (21)

The practice argued that, because its reinstatement had retroactive effect, the employment agreement likewise should have been retroactively reinstated. (22) The court disagreed, ruling that the covenant not to compete could not be enforced.

The ruling in Parvaiz was somewhat limited to the facts, because the physician’s employment agreement specifically provided that the dissolution of the practice automatically terminated his employment agreement. However, even in the absence of such a contractual provision, a practice may be precluded from enforcing its restrictive covenants if the practice cannot legally provide services to its clients. In Joseph Frazier, D.D.S., and George D. Dallas, D.D.S. v. Dettman, (23) a partner of a dissolved dental partnership brought an action, both in his capacity as an individual partner and on behalf of the partnership, to enforce a restrictive covenant in his former employee’s employment agreement. The practice hired the defendant, a licensed dentist, to perform dental services for its patients. The dentist’s written employment agreement contained a restrictive covenant, prohibiting him from performing dental services in McHenry County for two years after the termination of his agreement. Eventually, the partners decided to dissolve the practice and go their separate ways. The dissolution agreement allowed either of the partners to hire any of the former employees of the practice, and, in the event any of the former employees were so hired, the partnership would waive such employee’s covenant not to compete while in the process of winding up its affairs. The plaintiffs alleged that the dentist verbally accepted, but later declined, an offer from one of the former partners to work for his new firm, and proceeded to open his own practice in McHenry County. The plaintiffs sought a temporary restraining order prohibiting the dentist from violating his covenant not to compete. The dentist filed a Section 2-619 motion to dismiss, arguing that the covenant was unenforceable since the partnership had been dissolved. The trial court granted the temporary restraining order, which was vacated on the dentist’s interlocutory appeal. Upon remand, the trial court denied the request for a preliminary injunction and granted the dentist’s motion to dismiss.

On appeal, the Illinois Appellate Court, Second District, affirmed the dismissal of the complaint on the grounds that the former practice did not have any right to enforce the covenant not to compete. The court noted that, upon dissolution, a partnership is not immediately terminated, but continues until the winding up of the partnership’s affairs is concluded. (24) “Nevertheless,” the court reasoned, “the propriety of a winding-up partner bringing a suit to enforce a restrictive covenant which will only affect future conduct, when the partnership will presumably be nonexistent, is troublesome.” (25) In order to enforce a restrictive covenant in an employment contract, a business must show special circumstances to demonstrate a legitimate business interest, such as a near-permanent relationship with its customers. (26) The court noted that the partnership was dissolved and no longer engaged in the practice of dentistry, and concluded that “[i]t makes no sense to protect the partnership’s relationship with its patients when they are no longer serviced by the partnership.” (27)

The court continued: “As the partnership has no dentistry practice of its own which would constitute a legitimate business interest, there is nothing against which the defendant’s practice could impermissibly compete.” (28)

The partner argued that he had a fiduciary duty to wind up the affairs of the dissolved partnership, and that enforcing the covenant not to compete would preserve the goodwill of the business, a necessary part of the winding up process. The court disagreed, stating that “[t]he reputation of a professional partnership, such as partnerships of attorneys or physicians, depends upon the individual skill of its members, and there is generally no goodwill to be distributed as an asset upon the dissolution of such a firm.” (29) Therefore, the partnership was not allowed to enforce the former dentist’s restrictive covenant.

Upon the death of its sole owner, the practice may not be a valid entity in light of the requirements of the LLC Act, the PC Act, or any of the statutes which govern its particular profession. If the practice is no longer a valid entity, in light of Parvaiz and Dettman, it will not be able to enforce the restrictive covenants of its key employees. Key employees could leave the practice and compete, possibly taking clients and destroying the value of the practice as a result. In our experience, the Circuit Court of the Eighteenth Judicial Circuit has followed these decisions and refused to recognize the validity of a professional practice upon the death of its sole owner. As a result of one unpublished holding, a practice was not able to enforce its covenant not to compete against a former key employee. The problem is apparent: if the practice is unable to enforce key contracts, the deceased professional’s heirs may be left holding a practice that, in terms of value, is a shadow of its former self.

Ethical Considerations

In addition to the financial concerns detailed above, there may be ethical rules to consider in managing the practice after the death of its owner, depending on the particular profession. For instance, Rule 1.7(c) of the Illinois Rules of Professional Conduct provides that the estate of a deceased lawyer may sell his or her law practice, including goodwill, if it gives written notice to each of the firm’s clients regarding the proposed sale, the client’s right to retain other counsel or to take possession of their file, and the fact that the client’s consent to the proposed transfer will be presumed if the client does not object within 90 days of receiving the notice. However, the estate needs to be mindful of the restrictions and limitations imposed by the comments to Rule 1.7. Comment 7 states that the estate cannot provide a potential purchaser with access to any client-specific information relating to the representation, or access to the file generally, without the client’s informed consent. Also, Comment 11 makes clear that any lawyers participating in the sale of the practice are subject to various ethical obligations, including the obligation to exercise competence in identifying a qualified purchaser (pursuant to Rule 1.1); the obligation to avoid disqualifying conflicts and to secure the client’s informed consent for conflicts that can be waived (pursuant to Rule 1.7); and the obligation to protect information relating to the representation (pursuant to Rules 1.6 and 1.9). A deceased lawyer’s estate or personal representative must also be aware of Rule 5.6. Rule 5.6 prohibits a lawyer or law firm from making any agreement that restricts the right of a lawyer to practice after termination of the relationship, except in the limited context of restrictions incident to provisions regarding retirement benefits. The American Medical Association’s Code of Medical Ethics provides additional considerations for the estate of a deceased physician. Rule 7.03 states that, when a physician dies, their patients should be notified and urged to find a new physician and that, upon authorization, their records will be sent to the new physician. The rule also provides that any records which may be of value to the patient and which are not forwarded to a new physician should be retained, either by another physician or such other person lawfully permitted to act as a custodian of the records. Rule 7.04 indicates that the estate of a deceased physician may sell the elements of his or her practice, including goodwill. However, in doing so, the estate must ensure that all medical records are transferred to another physician or entity that is held to the same standards of confidentiality and is lawfully permitted to act as a custodian of the records. The estate is also required to notify all active patients that the practice is being transferred to another person or entity that will maintain their records and that, at the patient’s written request and within a reasonable time, their records or copies thereof will be sent to another physician of their choice.

These are only two examples of professional ethics rules. An estate planner should learn whether his client’s profession has its own ethics rules, and whether such rules may apply to the transfer of the business upon the client’s death.

Pre- and Post-Death Estate Planning Solutions

A comprehensive estate plan for an attorney, physician, dentist, or other professional should address these problems before they arise. Certain steps can be taken while the professional is still alive to ease the transition of his or her practice post-death. While meeting with the client to craft their estate plan, the estate planning attorney should ask them to identify trusted colleagues or key employees who would be capable of, and eligible to, own the practice after the client’s death. The client could, while still alive, decide to sell an interest in the practice to such an individual. Or, the client may draft their estate plan or the practice’s organizational documents to provide that, upon the client’s death, his estate will sell the practice to an eligible professional at a price based on an established formula. Such an agreement would be beneficial to all parties involved: the estate would receive liquidity for its illiquid interest in the practice, the practice would continue to stay in business and would be able to enforce any restrictive covenants with its employees and other beneficial contracts, and the new owner could continue the practice or act as a custodian while searching for a permanent buyer. Liquidity concerns within the business itself can also be alleviated with proper advanced planning. If the firm or heirs take out a life insurance policy on the professional’s life, the proceeds can be used after death to pay employee salaries and other expenses, as well as to compensate another licensed professional for their time in managing the firm during the transition period. By adequately planning for these contingencies, the estate planning attorney and client can ensure that the hard-earned value of the client’s practice will be preserved for his or her heirs.

Upon the death of the professional, his or her spouse, children, or personal representative must be aware of any elections that must be made to continue the practice. For example, a dentist’s personal representative should know that, after his wife’s death, he will need to follow the requirements of 225 ILCS 25/38.2 to continue the dental practice and preserve value for her estate. The personal representative must act promptly. The time period for them to make the proper notifications and elections to keep the practice in business may be 30 days or less.

This article is only intended to provide a brief summary of the possible problems associated with the death of a sole owner of a professional practice. Estate planners and clients may be able to come up with other solutions to these problems. However, the most important thing for the estate planner to do is to understand the problem and work with the client on how to solve it. With adequate advanced planning, the estate planner and client can preserve the value of the client’s practice after his death.


Aaron T. Troy is an Associate at Rolewick & Gutzke, P.C. in Wheaton, whose practice is focused primarily on probate litigation and administration.

David F. Rolewick is a Partner of Rolewick & Gutzke, P.C. in Wheaton, whose practice concentrations include estate planning, probate, and professional standards and misconduct. Mr. Rolewick is also a member of the Trusts and Estates Section Council.


Citations

(1) 805 ILCS 180/1-1 et seq.
(2) 805 ILCS 180/35-45(8)(A).
(3) 805 ILCS 180/35-3(c).
(4) Id.
(5) 805 ILCS 180/15-5(b)(3).
(6) 805 ILCS 180/35-1(3).
(7) 805 ILCS 10/1 et seq.
(8) 805 ILCS 10/11.
(9) Id.
(10) 805 ILCS 15/13.
(11) 225 ILCS 25/38.2(a).
(12) Id.
(13) 225 ILCS 305/21.
(14) Id.
(15) 225 ILCS 325/23(b).
(16) 225 ILCS 325/23(e).
(17) 225 ILCS 450/14(b)(2).
(18) 225 ILCS 450/9.01(a).
(19) 379 Ill.App.3d 567 (1st Dist. 2008)
(20) Id. at 572 (citing Retina Services, Ltd. v. Garoon, 182 Ill.App.3d 851 (1st Dist. 1989)).
(21) Id. at 574.
(22) Id. at 573 (citing 805 ILCS 5/12.45(d)).
(23) 212 Ill.App.3d 139 (2d Dist. 1991).
(24) Id. at 144 (citing 805 ILCS 206/802).
(25) Id. at 145.
(26) Id. at 145-46 (citing Hamer Holding Group, Inc. v. Elmore, 202 Ill.App.3d 994, 1007 (1st Dist. 1990)).
(27) Id. at 146.
(28) Id.
(29) Id. (citing Cook v. Lauten, 1 Ill.App.2d 255, 260 (1st Dist. 1954)).

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