Personal goodwill, purchase agreements, and covenants not to compete.

• Author: Steinmetz, Adam

In general, the disposition of a corporation through an asset sale will result in two levels of tax--taxable gain to the corporation and a taxable distribution to. the shareholders. A common strategy for shareholders of closely held corporations to avoid this double tax involves the assertion that a portion of the disposition of the business relates to the sale of personal goodwill of the shareholder and, therefore, a portion of the purchase price should be taxed as capital gain to the shareholder directly.

The concept of personal goodwill is well-established dating back to the decision in Martin Ice Cream Co., 110 T.C. 189 (1998). In recent years, however, decisions in Muskat, 554 F.3d 183 (1st Cir. 2009), Howard, No. 10-35768 (9th Cir. 8/29/11), and H & M, Inc., T.C. Memo. 2012-290, have highlighted the importance of covenants not to compete and asset purchase agreements in establishing the existence of personal goodwill.

Background

Martin Ice Cream involved a father and son who operated an ice cream distribution business through a corporation. The court determined that the success of the business depended entirely on the father, who had personal relationships with supermarket owners and an oral agreement with the founder of Haagen-Dazs to distribute a new line of super-premium ice cream to supermarkets. At no time did the father have an employment agreement with Martin Ice Cream (MIC). Following the purchase of Haagen-Dazs by Pillsbury, negotiations between MIC and Haagen-Dazs ensued for the acquisition of MIC's ice cream distribution business. The father and son disagreed on the future of the business and decided to split the assets of the corporation in what was meant to be a tax-free split-off under Sec. 355. The court found that the transaction failed the requirements of Sec. 355 and, therefore, MIC was subject to tax on the distribution of appreciated property under Sec. 311.

In determining the tax impact to M1C, the court analyzed whether the father transferred certain intangible assets to the corporation, or if the father retained these intangible assets personally. The court held that the success of the business depended entirely on the father's relationships in the market and his oral agreement with the founder of Haagen-Dazs, which represented valuable intangible assets. These assets could not be considered to be owned by MIC because the father never entered into a covenant not to compete or any other agreement with MIC that...