Personal goodwill: alive and well?

• Author: Gruidl, Nick

A pair of recent decisions calls into question whether the sale of personal goodwill is still available as a tax planning strategy. In both Solomon, T.C. Memo. 2008-102, and Muskat, No. 08-1513 (1st Cir. 1/29/09), the courts held that the purported sales of personal goodwill were in fact compensatory payments under covenants not to compete.

So is personal goodwill dead? No. A closer look at each case shows that with the correct set of facts and the proper planning, Personal goodwill remains a viable tax planning idea for owner-managed businesses. However, these cases give taxpayers and advisers fair warning that the IRS is willing and able to attack bad fact patterns, shortcuts, and last-minute tax advice.

Background

The sale of personal goodwill held directly by the selling shareholder avoids corporate-level tax and results in long-term capital gain (assuming the goodwill has been held by the taxpayer for more than 12 months). With current corporate and top individual tax rates of 35%, the benefits of the sale of personal goodwill are often quite significant to the seller. Similarly valuable to the buyer is the amortizable step-up in asset basis obtained upon the acquisition of personal goodwill from the seller that would not be available if the entire consideration were paid for the stock of the corporation.

As a result of double taxation of corporate earnings, the identification of personal goodwill as a separate asset occurs most often within the context of the sale of closely held corporations (either closely held C corporations or S corporations within the 10-year Sec. 1374 built-in gain period).

True to its name, the asset personal goodwill must meet the definition of goodwill from a tax perspective, and it must be owned by an individual. Goodwill is defined in legislative history, regulations, and numerous court decisions. The consensus is that goodwill represents the intangible qualities that bring with them continued patronage. (See H.R. Rep't 103-111,103d Cong., 1st Sess., House Committee Report to the Omnibus Budget Reconciliation Act of 1993, P.L. 103-66; Regs. Secs. 1.197-2(b)(1) and (2); Houston Chronicle Pub. Co., 481 F.2d 1240 (5th Cir. 1973), cert. denied, 414 U.S. 1129; Winn-Dixie Montgomery, Inc., 444 F.2d 677 (5th Cir. 1971); Killian, 314 F.2d 852 (5th Cir. 1963); Nelson Weaver Realty Co., 307 F.2d 897 (5th Cir. 1962); Karan, 319 F.2d 303 (7th Cir. 1963).)

Tax Court precedent establishes that when an individual does not...