* A separate sale of personal goodwill can avoid negative tax consequences,
* Personal goodwill should be distinguished from business goodwill when planning the sale of a closely held business,
* Learn how to establish the existence of personal goodwill and its separate transfer when selling a business.
Selling a business can require some of the most important tax planning an owner may ever need. That is particularly the case where a business has operated as a closely held C corporation and the proposed structure of the deal is an asset sale. In this situation, the owner can often significantly reduce his or her tax liability on the sale of the business by selling his or her personal goodwill associated with the business separately from the business's assets. However, to ensure a sale of personal goodwill is respected, an owner should take steps before or during the sale transaction to establish the existence of personal goodwill and that it has been separately transferred.
This article offers practical guidance to practitioners helping clients to take advantage of this effective tax strategy early in tax planning, by explaining the importance of identifying the goodwill associated with the business, determining its ownership and value, and negotiating its sale and transfer. Through reviewing court decisions, this article also helps practitioners avoid potential planning pitfalls.
A taxable sale of assets by a C corporation, an S corporation with earnings and profits, or an S corporation subject to the built-in gains tax (each a "target corporation"), followed by a liquidation or distribution of the sale proceeds to shareholders, normally results in a double tax at the corporate and shareholder levels.
While double taxation can be avoided if the transaction is structured as a stock deal, with the shareholders selling their stock in the target corporation, a purchaser may prefer an asset deal for at least three reasons, including:
In an asset deal, the purchaser gets a stepped-up, fair market value basis in the acquired assets equal to the price paid and any liabilities assumed (the purchase price), and will therefore get higher depreciation and amortization deductions than the target corporation was enjoying.
Unlike in a stock deal, which takes the target corporation with all its liabilities, known or unknown, an asset deal allows the purchaser to select which liabilities, if any, it will assume.
Similarly, an asset deal allows the purchaser to select which assets it will purchase, rather than, as in a stock deal, all of the target corporation's assets, wanted or unwanted.
Few strategies are available for avoiding the double tax cost from a taxable sale of assets. The most frequently used strategies involve payments directly to the shareholders under employment, consulting, and noncompetition agreements. While payments to the shareholders under those agreements will be taxed only once, at the shareholder level, those payments will constitute income to the shareholders taxable at ordinary income tax rates, and the employment and consulting payments will be subject to employment taxes as well.
Another strategy involves a shareholder's sale of the personal goodwill (defined below) associated with the operation of the target corporation. For the strategy to work, it must be demonstrated that goodwill in fact exists, that it is both salable and transferable to a purchaser of the target corporation, and that it is personal goodwill owned by a shareholder rather than business goodwill owned by the target corporation itself.
Summary of Tax Benefits
A shareholder's sale of personal goodwill creates significant income tax benefits for the shareholder of the target corporation. A sale of personal goodwill, if respected by the IRS, creates long-term capital gain to the shareholder, taxable at up to 23.8% (maximum capital gain rate of 20%, plus the 3.8% net investment income tax) rather than ordinary income to the target corporation, taxable at up to 35% plus an additional tax of up to 23.8% on the remaining balance of the purchase price distributed by the target corporation to the shareholder, leaving the shareholder with potentially approximately 76 cents rather than 49 cents for every dollar of value for goodwill after federal income tax.
In other words, the income tax is potentially more than two times (51% versus 23.8%) as much if the payments are made first to the target corporation rather than to the individual for a capital asset. And, if the choice is between personal goodwill and noncompetition payments to the shareholder, the difference is taxation at a federal rate of up to 23.8% for personal goodwill, versus as much as 39.6% for noncompetition payments.
Regs. Sec. 1.197-2(b)(1) defines goodwill as "the value of a trade or business attributable to the expectancy of continued customer patronage," and that "[t]his expectancy may be due to the name or reputation of a trade or business or any other factor." In Rev. Rul. 59-60, the 1RS describes goodwill thus:
In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value. The Tax Court, in Staab, (1) has stated that goodwill is an intangible asset consisting of the excess earning power of a...