Personal Goodwill Can Minimize the Corporate Double Tax When Selling the Assets of a Business
By: SEAN P. KEARNEY
September 2003
One of the most common tax dilemmas arises when an owner goes to sell a business and discovers the net after-tax proceeds substantially reduced by the dreaded double tax. One solution is to allocate part of the purchase price to the personal goodwill of the owner. This is often a win/win proposition; the seller benefits from a single tax at the favorable capital gains rate while the buyer is typically no worse off than if only corporate goodwill had been purchased.
The Problem
The earnings of a C corporation are taxed both at the corporate level and when they are distributed to shareholders. Many corporations manage this by paying deductible bonuses, royalties, etc. to the owners to keep corporate profits low. The problem often reappears when the owner sells the business. Most buyers will not purchase the stock of the business for liability and tax reasons so the transaction is usually structured as an asset sale. This sale will be subject to the double tax, and the usual methods of minimizing the double tax will be insufficient to eliminate the double tax in the year of the sale.
If the buyer will not agree to a stock purchase, the owner has a limited number of options to minimize the double tax. Some of the payments can be made directly to the owner as employment, consulting, or non-compete payments, but these will be subject to ordinary income tax rates and possibly employment taxes as well. These payments must also have economic substance with respect to actual employment or consulting services performed. The most effective solution may be to allocate a portion of the purchase price to the personal goodwill of the shareholders.
The Personal Goodwill Solution
In a 1998 decision known as Martin Ice Cream, a creative taxpayer successfully argued that the goodwill of a business can be bifurcated into goodwill owned by the corporation and goodwill owned by an owner. The taxpayer convinced the Tax Court that the corporation's success was largely based on the personal reputation and industry contacts of one of the owners, and that most of the goodwill was personal to the owner and had not been transferred to the corporation. Based on this bifurcation of goodwill, the owner's personal goodwill is a separately saleable asset that avoids the double tax and is subject to favorable capital gains rates.
The concept of personal goodwill was bolstered in another 1998 case, Norwalk v. Comm'r, TC Memo 1998-279. This case involved the liquidation of an accounting practice and the Tax Court applied the theory of personal goodwill and found that the intangible asset attributable to the client relationships was the property of the individual owners and not the corporation. Since these decisions, there has been little additional authority with respect to personal goodwill.
If an owner is contemplating a personal goodwill allocation, the primary issues are determining just what is the intangible asset for the particular business and how much of the purchase price can be allocated to it. The asset is generally viewed as some combination of the reputation, personal relationships with customers and suppliers, and expertise of the shareholder. The best case is one where the customers and suppliers perceive themselves as dealing with the individual shareholder rather than with the legal entity. A service business is most likely to support this position, although Martin Ice Cream itself demonstrates it can apply to other types of businesses.
The value associated with the asset is often negotiated between the buyer and seller, just like the allocation of the purchase price to other tangible and intangible assets that are being acquired. It is sometimes useful to have a third-party appraisal support the allocation. In the author's experience, allocations to personal goodwill have ranged from 10% to 90% of the total purchase price, depending on the particular facts and circumstances of the transaction.
Summary
If the corporate double tax is looming large when selling the assets of a business, consider if an allocation to personal goodwill is a solution to this common tax planning dilemma.