The value you bring to your company—and the tax savings
you could see as a result
First of all, personal goodwill is a relatively new concept that not every legal or tax practitioner has heard of. The phrase “personal goodwill” appears absolutely nowhere in the Internal Revenue Code, United States Code Annotated or any state statute. It was given life in court cases over the past 20 years and is roughly defined as “the asset that generates cash profits of the enterprise that are attributed to the business-generating characteristics of the individual, and may include any profits that would be lost if the individual were not present.”
Quite simply, personal goodwill is the intangible value a person (usually the owner or CEO) brings to the company. It stands in contrast to traditional goodwill, which is the value attributable to the company itself, arising from intangible advantages such as location, customer quality, employees, etc. While this dichotomy may seem insignificant, personal goodwill is an important concept to legal practitioners for three reasons.
Federal Tax Ramifications
When selling any corporation, the buyer is always interested in purchasing the assets of a company to gain the advantage of lesser liability and the tax advantage of depreciating assets with a stepped-up basis against income to reduce taxable income. While an asset sale gives rise to tax benefits to the buyer, the seller suffers multiple tax detriments, especially in the case of selling assets of a C Corporation. Almost certainly, in any sale, the seller will face:
- Taxes arising from ordinary income
- Taxes arising from depreciation recapture (also at the ordinary income tax rate)
- Taxes arising from capital gains, and
- In the case of a C Corporation, double taxation when the proceeds are distributed to the owners.
When selling an S Corporation, partnership, sole proprietorship or other pass-through entity through an asset or stock sale, ordinary goodwill does not present any problems. The sale of the goodwill gets taxed once, at the seller’s level as a capital asset. The tax rate on the gain is presently 15 percent.
However, the problems begin when selling a C Corporation through an asset sale. Ordinary goodwill creates a tremendous tax burden that is not present in the sale of a flow-through entity. During the sale, ordinary goodwill is taxed at the corporate level. Since C Corporations do not get the benefit of the lower capital gains tax rates, the capital gain is taxed at the corporation’s ordinary rate. This federal tax rate can be as high as 39 percent at certain income levels. Once ordinary goodwill is taxed at the corporate level, it is given to the seller, usually in the form of a dividend distribution. When given to the seller, it is taxed at the federal dividend rate of 15 percent. This means that of every $100 given to the selling corporation as part of an asset sale, potentially $48 of it will be paid to the federal government as taxes. In addition, we might have to deal with state taxes.
Along comes the concept of personal goodwill. As mentioned previously, the phrase “personal goodwill” does not appear anywhere in the Internal Revenue Code. Two tax cases gave rise to the concept of personal goodwill for federal tax purposes, and these two cases contain the definition for tax purposes.
In the Martin Ice Cream case (110 TC 189 (1998)), Arnold Strassberg was the co-owner of a company known as Martin Ice Cream Company. During his tenure with the company, he became a distributor of ice cream from Häagen-Dazs to multiple grocery stores under a non-written “handshake” agreement. In the mid-1980s, Pillsbury acquired Häagen-Dazs. Rather than allowing Arnold to continue in the distributorship, middleman position, Pillsbury acquired Arnold’s company, the Martin Ice Cream Company. Forty-six percent of the purchase price was allocated to Arnold’s seller’s rights, or what is now known as “personal goodwill.” When the case went to court, the Tax Court held that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the company. This landmark tax case gave rise to personal goodwill.
Additionally, Norwalk (TCM 1998-279 (1989)) found that the personal relationships of a group of accountants were the property of the individual owners and not the corporation itself, hence affirming the existence of personal goodwill.
When a seller is in a position similar to those above, it is most advantageous to split personal goodwill off from company goodwill. During the negotiation phase of the sale, the seller must create a separate personal goodwill contract stating that some of the goodwill being sold is personal goodwill. At the same time, the seller should not engage in an employment agreement. If an employment agreement is part of the deal, theoretically, the goodwill is an asset of the company being sold and not personal goodwill. Practitioners have, in the past, sold 10 percent to 90 percent of the goodwill as personal goodwill in business sales. This amount should be based on a reasonable and objective estimation of the two values, while keeping in mind that more personal goodwill means less tax.
Personal goodwill is more likely to exist in smaller, service-type companies. Characteristics of companies with personal goodwill include: “relationship” dependent, no written contracts, no written property rights in the company, owner/employee controls the company and earnings do not support the transaction price. Companies that would be heavier on traditional goodwill feature the following characteristics: “capital” dependent, written employment contracts, written property rights, no controlling owner and earnings support a transaction price. When valuing a company or working on transaction allocation details, these factors can and should be considered to support a correct allocation.
Divorce – Equitable Division
Practitioners involved with divorce work routinely are unfamiliar with the general concepts of valuation when a business is present. Valuation specialists are sometimes not even used to appraise businesses. In these cases, the trier of facts will essentially make an educated guess as to the value of the business using rules of thumb that may be erroneous. Furthermore, and of even greater consequence, in cases not retaining experts, company goodwill and personal goodwill cannot be differentiated from one another, placing the business owner’s case in jeopardy. Essentially, in any case involving a business interest, valuation specialists should be employed up front.
Proceeds derived from the sale of personal goodwill are not subject to a spouse’s claim for equitable distribution. In the Florida case of Thompson v. Thompson (576 So. 2d. 267, 270 (1991)), an attorney divorced his wife. The wife claimed that the entire law practice was a marital asset subject to 50 percent division. The husband, on the other hand, argued part of the law practice’s value was not merely “professional” or company goodwill, but also “personal goodwill.” The court agreed with the personal goodwill concept and allowed personal goodwill to become a precedent in the state of Florida. The court defined “personal goodwill” as goodwill that depends on the continued presence of a particular individual, and which is not a marketable asset distinct from such individual. Although the personal goodwill was not an “asset” of the marriage, it could be used in determining alimony payable to the wife. Cases establishing personal goodwill in other states have been written as well. The cases are not always used, as many practitioners do not know of the concept or even understand it.
Along with depreciation recapture and ordinary gains, capital gains also arise during asset sales. Capital gains are normally taxed at preferential rates. If the company is a C Corporation, low capital gains rates do not apply. The C Corporation pays capital gains at the same rate as all other income they receive.
That said, S Corporations, LLCs and sole proprietorships will benefit from realizing capital gains as opposed to any other gain. Any amount of money paid for an item beyond its original amount will qualify for capital gain treatment in an S Corporation or LLC.
For example, a company buys $100,000 worth of equipment, then deducts $100,000 of depreciation expenses. If the company then sells the equipment for $110,000, the result is $100,000 in depreciation recapture (subject to ordinary income tax treatment) and $10,000 of capital gains subject to 15 percent taxes. Since capital gains result in lower taxes, it is best to try to justify all the capital gains as possible rather than depreciation recapture or ordinary income.
Special Considerations for C Corporations
C Corporations have special considerations to ponder. Generally C Corporations are taxed twice. As such, any gain made from an asset sale will be taxed at the corporate level. Once it is taxed, any money distributed to the owner as a dividend is then taxed again at the rate of 15 percent. The result is that the owner and company may pay nearly 50 percent in taxes for gains made in an asset sale. It is best to time the sale of the business to close before December 31, 2010. Given the time it takes to sell a business, it is generally best to consider selling soon.
Additionally, C Corporations, as mentioned above, do not benefit from the preferential tax rates other entities benefit from. The capital gains of a C Corporation are figured in with the ordinary tax rate of the corporation. This can mean that capital gains generally will result in a tax liability of up to 35 percent at the corporate level alone.
There is also special case law now in existence reducing the double tax/capital gains burden of the C Corporation taxpayer in a business sale. Currently the tax interpretations allow for personal goodwill to be purchased by a buyer separate from the business transaction. Selling the personal goodwill, to the extent justified, allows the seller to escape a layer of tax to the extent of the personal goodwill sold and take advantage of the lower tax rates of an individual at 15 percent.
Stock sales differ completely from asset sales. A stock sale, in this context, is when a person or entity sells his or her stock to a third party for value. Stock sales tend to be the best tax scenario for a seller because the gain is primarily capital gain taxed at 15 percent, no matter whether stock in a C or S Corporation is sold.
In a stock sale, the seller will look to his or her basis in the entire company as opposed to each individual asset. Each individual asset’s basis is not adjusted in a stock sale, as opposed to an asset sale. As such, because the asset bases are not adjusted, the buyer does not gain a tax advantage and the seller does not suffer a detriment. Stock sales result in a less complicated and less costly tax scenario for the seller as opposed to asset sales.