Sale of personal goodwill--the executive's parachute.

• Author: Wells, Thomas O.

The sale of personal goodwill is desirable by an executive because a) proceeds are generally taxable to the executive as long-term capital gains and not as ordinary income; b) funds are transferred directly from the buyer to the executive (and not through the executive's company subject to the company's creditors); and c) personal goodwill is not subject to equitable distribution in connection with an executive's divorce. Under [section] 197 of the Internal Revenue Code of 1986, as amended (the "Code"), the tax treatment to the buyer is the same regardless of whether the executive recognizes long-term capital gain from the sale of personal goodwill or ordinary income for a noncompete payment. Therefore, you have the rare occurrence in federal income tax law in which there is no friction between the buyer and executive. Finally, the creation of personal goodwill for the executive-shareholder is critical to avoid a corporate income tax under Code [section] 31.1 or [section] 336 when a corporation attempts to convert to a limited liability company that is taxable either as a partnership or as a disregarded single-member entity. This article examines the sale of personal goodwill by defining it, reviewing pretransaction methods to create and transfer it, analyzing the benefits of selling it, and explaining the tax treatment to the buyer in purchasing it.

Defining Personal Goodwill

1) Definition for equitable distribution. The Florida Supreme Court in Thompson v. Thompson, 576 So. 2d 267, 270 (1991), defined "personal goodwill" as goodwill that depends on the continued presence of a particular individual that is not a marketable asset distinct from such individual. In Thompson, an attorney was divorcing his spouse and his spouse was claiming equitable distribution in his law practice. Equitable distribution entitles each spouse to a presumption of 50 percent equal ownership in all marital assets pursuant to F.S. [section] 61.075. The Florida Supreme Court determined that the spouse was entitled to equitable distribution in the "professional goodwill" of the law practice provided that such goodwill must be a business asset having value that is separate and distinct from the presence and reputation of the individual attorney. The court further stated that any value that attaches to an entity solely as a result of personal goodwill represents nothing more than probable future earning capacity that, although relevant in determining alimony, is not a proper consideration in dividing marital property in a dissolution proceeding.

2) Definition for tax law. The tax definition of personal goodwill is derived primarily from two Tax Court cases in 1998: Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998); and William Norwalk, Transferee, et al. v. Commissioner, TCM 1998-279 (1998).

In Martin Ice Cream, the Tax Court held that the personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. Arnold Strassberg was a major distributor of ice cream in the northeast U.S. who had started distributing ice cream in 1960, taking over a business that his father had started soon after World War II. In 1974, the founder of Haagen-Dazs approached Arnold to sell and distribute the "super-premium" ice cream, and Arnold became Haagen-Dazs first distributor to supermarkets. By the late 1970s, Martin Ice Cream Co., which was owned solely by Arnold's son, Martin, was distributing Haagen-Dazs ice cream to four major supermarket chains in the Northeast. However, neither Arnold nor Martin Ice Cream Co. had any written distribution agreement with Haagen-Dazs. Martin preferred the wholesale distribution of ice cream to small independent grocery stores and food service accounts rather than Arnold's focus of distribution to supermarkets.

In the mid-1980s, Pillsbury acquired Haagen-Dazs and was seeking to sell directly to retail supermarkets and eliminate its distributor network. In 1988, Haagen-Dazs sought to acquire and terminate its distribution agreement with Arnold and Martin Ice Cream Co. Martin Ice Cream Co. created a wholly owned subsidiary with the goal of spinning off the supermarket ice cream sale business to the new subsidiary with the distribution ice cream to small independent grocery stores and food service accounts to be retained by Martin Ice Cream Co. Arnold was named sole shareholder of the subsidiary in exchange for stock that was granted to him in Martin Ice Cream Co. Pillsbury executed an agreement with Arnold and the new subsidiary to acquire the rights to the supermarket ice cream sale business in exchange for $1,430,340. Arnold also signed a bill of sale and an assignment of rights. To protect its rights, Pillsbury requested that Arnold and Martin both sign noncompete agreements.

The Tax Court attributed the purchase value primarily to two assets: Arnold's personal relationship with the...