Personal goodwill and the net investment income tax.

• Author: Hesse, Christopher W.

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In the sale of a C corporation, goodwill in many cases is the property of a shareholder rather than of the corporation. The Tax Court has found this to be the case where the success of the corporation depended on the shareholder's ability and reputation and there was no noncompete agreement between the shareholder and the corporation. The shareholder must recognize the income from the sale of the goodwill as capital gain.

However, a related question arises: Is that gain subject to the net investment income tax under Sec. 1411? Many commentators seem to assume that it is. However, a careful analysis of the net investment income tax and passive activity loss regulations should lead to the opposite conclusion for most sales of personal goodwill. This article looks at the circumstances under which goodwill can be considered a shareholder's property and why the income from the sale of goodwill developed by the personal efforts of the individual should not be subject to the net investment income tax.

Sales of Goodwill

Double-taxation arises upon the sale or distribution of C corporation assets in a C corporation liquidation or upon the sale or distribution of an S corporation's assets subject to the built-in gains (BIG) tax in an S corporation liquidation. The corporation pays tax on the sale or distribution of the assets. The shareholders pay tax again on the amount of their liquidation distribution less their stock basis.

However, if intangible assets associated with a sale are properly characterized as the property of the shareholders, the double-taxation is reduced. For example, upon a sale of a business, a portion of the consideration might be for the selling shareholder's covenant not to compete or to contractually bind the individual to perform consultation services to the purchaser of the business. These types of arrangements will result in ordinary income (not capital gain) to the selling shareholder rather than income to the corporation.

A number of court cases have addressed the issue of whether, in the sale of a corporation, goodwill was the property of the selling corporation or of the selling shareholder. In Martin Ice Cream Co. (1) the Tax Court reviewed the value of assets split off from a corporation in preparation for a sale. The court divided the intangible assets into two groups. One group, including assets such as business records of the business, was the property of the corporation. The other group, the intangibles assets, consisting of an oral contract made by one of the corporation's two shareholders with the corporation's primary supplier and that same shareholder's relationships with customers of the business, was found to be assets of that shareholder. A factor in the decision was the lack of any noncompete agreement between the shareholder and the corporation. The issue was how to determine the value of a split-off corporation that did not qualify for nonrecognition of corporate gain under Sec. 355. The IRS asserted that the value of the corporation split-off included goodwill. The court found that the goodwill belonged to the shareholder and should not be included as an asset of the corporation in determining the corporation's value. (2)

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