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Tax

Tax Benefits of Personal Goodwill

Goodwill, as defined under the Treasury Regulations, is an intangible asset that represents the value of a trade or business that is attributable to the expectancy of continued customer patronage. The expectancy may be due to the name or reputation of a trade or business or any other factor.

There are two types of goodwill – business goodwill and personal goodwill. Business goodwill is associated with the assets of a business. It can include, among other assets, processes, reputation and work force. Personal goodwill is associated with an individual and can include relationships, expertise and reputation.

In the disposition of a corporate business that is taxable as a Subchapter C-Corporation (“C-Corp”), the differentiation between personal goodwill and business goodwill results in significantly different tax treatment upon disposition. A disposition of the assets of a C-Corp will result in a tax on the gain on sale of the assets at the corporate level and another tax as a dividend at capital gains rates on the distribution of the proceeds. This results in a conflict between the buyers and sellers of C-Corps. Buyers desire to buy assets because the tax basis of the assets is stepped up to fair market value for post-acquisition depreciation and amortization, enhancing post acquisition cash flow. Sellers desire to sell stock that results in one level of tax at capital gains rates. Business goodwill sold by a C-Corp is subject to the aforementioned double tax. Personal goodwill that is attributable to a shareholder is taxable to the individual as a capital gain. The classification as personal goodwill mitigates some of the conflict between buyers and sellers of C-Corps, as the acquirer of personal goodwill will be able to amortize that goodwill.

Personal goodwill can exist in corporations that are closely held and where there are supplier and customer relationships that rest with the owner shareholder. The landmark case in the area of personal goodwill is Martin Ice Cream Co. v. Commissioner. In this case, the principal shareholder sold intangible assets to Haagen-Dazs that included his relationships with supermarket chains. The court held that the intangible assets were never held by the corporation because the corporation had never entered into a non-compete agreement. As a result, upon sale of the intangible assets to Haagen-Dazs, the principal shareholder signed consulting and non-compete agreements.

The concept of personal goodwill is well-grounded in the Martin Ice Cream case. The cases subsequent to Martin Ice Cream support the concept of personal goodwill. Subsequent adverse cases involved valuation and factual issues, but the concept of personal goodwill remains valid.

A subsequent adverse finding in a 2010 court case, Kennedy v. Commissioner, clarifies some of the issues that exist around the documentation of personal goodwill. In this case, the allocation of a portion of the purchase price to personal goodwill was completed after substantive negotiations of purchase price. Emails were discovered showing that both parties were aware of the favorable tax benefits. The IRS took the position that the allocations were tax-motivated and not supported by the facts, and the Court sided with the Service. Subsequent to that case, in H & M, Inc. v. Commissioner the IRS lost in its assertion that the allocation was not adequately documented in a situation where there were no adverse interests between the buyer and seller. The Tax Court held that while better documentation could have been obtained, the allocations were grounded in economic reality and were allowed.

In a case decided in the last couple of months, the Martin Ice Cream concept that personal goodwill was attributable to the shareholder operator was upheld. Bross Trucking, Inc. v. Commissioner was a case similar to Martin Ice Cream, with a twist. In that case, the sons of the owner formed a new company in the same line of business as Bross. Bross Trucking had some regulatory issues over the years that impacted the business’s ability to continue. The IRS asserted that there was a deemed distribution of appreciated property in the form of business goodwill assets to the owner operator who, in turn, gifted the assets to his sons. This resulted in corporate tax, gift tax, and penalties. The Court found that the assets were, in fact, personal goodwill and not property of the corporation. Since they were not property of the corporation, the assets were not business goodwill. Thus, corporate tax and penalties were overturned in this case.

A sale of personal goodwill by a selling shareholder as part of the overall sale of a C-Corp is a powerful tool. The case law in this area has set forth some criteria that should be followed and met:

  • The presence of a non-compete agreement between the selling shareholder and the company is strong indication that personal relationships and other intangibles are actually business goodwill and not personal goodwill;
  • Conversely, a non-compete agreement between the selling shareholder and the acquirer should be executed, as that furthers the argument that the intangibles were, in effect, not assets of the C-Corp;
  • The purchase price negotiations should address the personal goodwill transfer in advance. It should not be an after-thought; and
  • Despite the findings in the H&M case, a contemporaneous appraisal should be obtained.

If you have questions about this article or would like more information, please contact James Cordova at jcordova@windes.com or at 844.4WINDES (844.494.6337).

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