Personal Goodwill – A Neglected Business Asset with Tax Savings

Personal Goodwill – A Neglected Business Asset with Tax Savings

By Douglas C. Alexander

Useful clauses After years of growing a successful business, the culmination of those efforts is often a sale of the company to a new owner. For mature businesses which have been operated as taxable “C” corporations, this may present some serious challenges. Most buyers will push for a purchase of the assets owned and used by the company rather than a purchase of its stock, because of the ability to create tax basis in the assets which can then be deducted over varying lengths of time. Alternatively, the seller would prefer to sell his or her stock to trigger only one level of tax at lower capital gain rates. However, purchasers typically refuse to purchase stock because of the inability to deduct any of the purchase price paid, thus making the purchase far more expensive. If the seller agrees to sell the company assets, the sale results in taxes payable both at the corporate and individual levels, and the net proceeds to the seller suffer a serious bite.

Is there a solution to the differing desires of buyers and sellers? Is it possible to achieve a “win-win” result? If the business being sold owes its success largely to the efforts of the owner and his or her relationship with customers, as is often the case in professional practices and other personal service businesses, the answer is “Yes.” In any sale of assets, an evaluation of the assets being sold must be undertaken, and then the total purchase price must be allocated among those different asset classes. One asset that may be overlooked is the personal goodwill of the owner.

In William Norwalk et al. v. Commissioner, TC Memo 1998-279, the IRS argued that the value of an accounting practice included “customer based intangibles,” i.e., the clients. The accountants involved argued that because they were not restricted from leaving the corporation and serving the same clients elsewhere, the clients had “no meaningful value.” The court ultimately agreed with the taxpayers, stating that the “personal ability, personality, and reputation of the individual accountants is what the clients sought. These characteristics did not belong to the corporation as intangible assets, since the accountants had no contractual obligation to continue their connection with it.” The seller allocated a significant portion of the purchase price being paid for his business to his personal and professional goodwill. By doing so, he reported it as the sale of a personal asset, thus avoiding corporate tax on the proceeds and characterizing it as the sale of a capital asset that qualified to be taxed at lower capital gain rates. The IRS argued that the goodwill belonged to the corporation and should be treated as the sale of a corporate asset. The court disagreed. Because the owner had a close relationship with the customers and was not restricted from leaving the company and competing directly, the court concluded that the goodwill really belonged to the owner and not the company.

This strategy provides sellers of certain types of businesses with a new approach. Here is an actual example of a recent transaction we worked on. Our client, the seller, owned a medical practice operated through her corporation. No employment contract was in place and no restriction impeded the doctor from leaving the corporation and competing. The practice had a total appraised value of approximately $600,000, but the hard assets had a value of only $165,000. The appraiser agreed that $165,000 should be allocated to equipment and supplies, $35,000 to corporate goodwill, and the remaining $400,000 to the personal goodwill of the doctor. Of course the purchaser wanted a non-compete with the doctor; typically a portion of the purchase price is treated as consideration paid for the non-compete, but doing so produces ordinary income rather than capital gain income. Instead of following the historical pattern, we allocated the $400,000 to an assignment of personal goodwill and the doctor entered into the non-compete merely to protect the value of that goodwill asset sold. The result was a savings of over $80,000 in federal income tax alone, without even considering the elimination of the corporate level tax by making the allocation to the doctor personally.

The Norwalk case gives sellers a new option to use in structuring asset sales of “C” corporations. Buyers are usually agreeable because it does not produce an adverse tax consequence to them. Careful advance planning is required, and this approach is not appropriate in all cases. However, in the right situation, significant savings can be realized by applying the principles outlined by the court in this case. When you begin thinking about a sale of your business, give us a call to discuss the issues and alternatives.