Disposable Personal Goodwill, Frosty the Snowman, and Martin Ice Cream All Melt Away in the Bright Sunlight of Analysis

• Publication year: 2021

91 Nebraska L. Rev. 170. Disposable Personal Goodwill, Frosty the Snowman, and Martin Ice Cream All Melt Away in the Bright Sunlight of Analysis

Disposable Personal Goodwill, Frosty the Snowman, and Martin Ice Cream All Melt Away in the Bright Sunlight of Analysis

Bret Wells and Craig Bergez(fn*)

TABLE OF CONTENTS

I. Introduction..........................................170

II. Historical Background ................................172

A. Pre-1986 Law.....................................172

B. Tax Reform Act of 1986 ...........................174

C. Post-1986 Reaction ................................ 176

D. Section 7704 ...................................... 178

III. Substantive Analysis .................................. 180

A. Marketing Intangibles ............................. 184

1. Transfer Pricing Rules.........................185

2. Martin Ice Cream..............................191

3. Taxpayer Duty of Consistency..................196

B. Residual Goodwill Resides with the Business ......202

IV. Corporate Tax Reform Implications ....................209

V. Conclusion ............................................ 211

I. INTRODUCTION

The current rage in dispositional tax planning for closely-held C corporations is to bifurcate the sale transaction into two components comprising: (a) a sale by (i) the target C corporation's shareholders of their target C corporation stock or (ii) the target C corporation of its assets; and (b) a sale by some or all of the target C corporation's share

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holders of "personal goodwill" associated with the business conducted by the target C corporation. The documented purchase price paid for the first component of the transaction (either the stock of the C corporation or the assets of the C corporation) is based on a fair market value determination that excludes consideration of the personal goodwill component of the transaction. If successful, this tax planning technique allows the selling shareholders to report only shareholder-level capital gain on the personal goodwill component of the transaction and allows the buyer to claim that this portion of the purchase price is allocable to an acquired intangible, i.e., goodwill, that is amor-tizable over fifteen years under § 197.(fn1) More specifically, from the selling shareholders' perspective, if the first component of the transaction involves a sale of the target C corporation's assets, the portion of the purchase price attributable to the personal goodwill component of the transaction does not bear the burden of a corporate level of taxation. From the buyer's perspective, if the first component of the transaction involves a purchase of the target C corporation's stock, the portion of the purchase price attributable to the personal goodwill component of the transaction is not capitalized into the stock.(fn2)

This planning is premised on the position that certain goodwill associated with the target C corporation's business can be, and is in fact, owned for tax purposes, by one or more shareholders. If all goodwill associated with the target C corporation's business activities were in fact owned for tax purposes by the target C corporation, then the personal goodwill component of the transaction is properly viewed as a sale by the target C corporation of such goodwill creating a corporate-level gain, followed by a distribution from the target C corporation to the shareholders, which in turn creates a shareholder-level gain.(fn3) If,

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however, the personal goodwill can be, and in fact is, owned by the selling shareholders and can be, and in fact is, sold by the selling shareholders to the buyer for tax purposes, then its disposition is not subject to corporate-level taxation.

Although this planning has garnered much attention recently and could provide significant tax benefits if effective, we believe it deserves further scrutiny before being accepted as an appropriate component of dispositional tax planning for closely-held businesses. This planning technique also highlights the continuing horizontal equity problems associated with the current tax law's treatment of closely-held businesses. In Part II of this article, we discuss the place that this tax planning technique occupies within a historical context. In Part III, we set forth a substantive discussion of the issues raised by the technique. In Part Iv, we discuss the tax policy implications that are raised by the existing application of the corporate income tax regime. Finally, in Part v, we discuss some final thoughts about the implications of the analysis contained in this paper.

II. HISTORICAL BACKGROUND

A. Pre-1986 Law

The ability to distribute appreciated goodwill out of corporate solution without bearing corporate-level taxation on associated built-in gain was achievable under law existing prior to 1986. In General Utilities and Operating Co. v. Helvering,(fn4) the Supreme Court held that a distribution of assets by a corporation to its shareholders did not constitute a sale or exchange of the distributed assets and accordingly the distributing corporation did not incur a taxable gain or loss from the distribution.(fn5) The General Utilities doctrine, as it came to be known, was codified in the Internal Revenue Code of 1954 in old § 311(a)(2) as to nonliquidating distributions and in old § 336 with respect to liquidating distributions.

While the General Utilities doctrine protected corporations from incurring tax upon a distribution of assets, the shareholders would recognize shareholder-level gain on the distribution equal to the excess of the fair market value of the distributed assets over the shareholder's stock basis. When the shareholder later sold the distributed assets to

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a buyer, there was no further gain to be realized on the sale except to the extent the buyer paid more than the fair market value of the assets at the time of their distribution.(fn6) The buyer would take the assets with a basis equal to the buyer's purchase price. This technique was widely understood(fn7) and widely utilized.(fn8) The ability to distribute appreciated assets out of corporate solution without incurring a corporate-level tax is exactly what Congress deemed to be an area in need of fundamental reform in 1986.(fn9)

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B. Tax Reform Act of 1986

In 1986, save for distributions that qualify for non-recognition treatment under § 355,(fn10) Congress repealed the last vestiges of the General Utilities doctrine.(fn11) The intent of this major tax reform effort was to ensure that built-in gain property residing in corporate solution would be subject to corporate-level taxation when and if such property was distributed out of corporate solution(fn12) except where the taxpayer was able to meet the rigorous requirements of § 355. Congress viewed the repeal of the General Utilities doctrine as a major reform effort with broad-reaching impact. In this regard, the Tax Reform Act of 1986 (1986 Act) was premised on the "classic view" that a corporation should be taxed separately from and in addition to the tax imposed on its owners. Thus, corporate-level goodwill could no longer be distributed as part of a liquidating distribution to the shareholders without incurrence of a corporate-level tax. Congress authorized the Treasury Department to issue regulations to ensure that the purposes of the repeal of the General Utilities doctrine were not circumvented through the use of any provision of the law or regulations.(fn13) At the

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time, there were calls to adopt an integrated shareholder-corporate tax regime,(fn14) but those calls were rejected.

Moreover, the 1986 Act reduced individual tax rates to a maximum tax rate of 28% while the maximum corporate tax rate, which had historically been lower than the individual tax rate, was reduced to 34%. This reform's effect was that the combined all-in shareholder-corporate tax rate that applies to C corporations was raised more than 24% higher than the combined all-in owner-company tax rate that applies to pass-through entities (e.g., S corporations and partnerships).(fn15)

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C. Post-1986 Reaction

Notwithstanding the bold reform Congress instituted with the repeal of the General Utilities doctrine and its efforts to preserve the corporate tax base, Congress left taxpayers with the ability to choose whether to conduct their business activities in pass-through entities or through separately taxable C corporations. In response to the reforms implemented as part of the 1986 Act, the tax community has engaged in an ongoing effort to transform the manner in which business is conducted in the United States by migrating business activities into pass-through entity structures.(fn16) Perhaps as a result of this effort, an impressive number of C corporations have been electing to change from C corporation status to S corporation status.(fn17) This trend can be traced back to the adoption of the reforms implemented as part of the 1986 Act.(fn18) However, the utility of such conversions has limits.

In this regard, S corporation status allows pass-through treatment for income earned prospectively. However, § 1374 imposes a tax on a converted C corporation's built-in gains(fn19) that are recognized during

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the prescribed post-S election recognition period.(fn20) As a result, where possible, tax advisors have advised closely-held businesses...