Separating personal and business goodwill.

• Author: Arne, Darrell V.

In a variety of transactions, tax savings are available if goodwill can be allocated to the business owner, rather than the business entity. This article identifies such tax savings situations, as well as the judicial factors and methods used to support an allocation to personal goodwill.

A tax adviser faces a variety of situations in which a client's interests are best served by minimizing the value of business assets. For example, when a C corporation sells its assets and distributes the proceeds to its shareholders, the overall tax liability can be reduced if some portion of the proceeds are allocated to the shareholders, rather than to the corporation. To the extent that goodwill exists in a corporate asset acquisition, a C shareholder may expect to retain an additional 27 cents for every dollar of goodwill allocated to the individual rather than to the corporation. (1)

Although it is not possible to simply assign consideration received in exchange for tangible and intangible assets titled in the corporate name, some flexibility may exist to characterize consideration paid for intangibles (such as goodwill, going-concern value and a covenant not to compete (CNTC)) as payments to the shareholder.

This article identifies situations in which a tax adviser may need to assess whether intangible assets (such as goodwill) belong to the business entity or the business owner. It also discusses court decisions on personal versus business goodwill, the factors generally used in classifying goodwill as personal and methods involved in making an allocation to business and personal goodwill.

Need for a Goodwill Allocation

The determination of whether goodwill exists and, if so, whether it belongs to the business entity or to the individual, is relevant whenever tax or economic benefits may be realized by minimizing the business entity's valuation. There may be many such situations, including the six transactions discussed below.

Corporate Asset Sale

If a corporation sells its assets, the gain or loss at the entity level is the difference between the amount realized and each asset's basis. If the entity thereafter liquidates, with the after-tax consideration distributed to shareholders, Sec. 331 requires them to recognize gain or loss measured by the difference between the amount realized and their stock basis. To the extent that goodwill exists in the business, its allocation to the shareholder (rather than to the corporation) will reduce the amount realized at the corporate level, thereby reducing any gain subject to corporate-level tax. This tax may apply to (1) a C corporation or (2) an S corporation subject to the Sec. 1374 tax on built-in gain (BIG), for which corporate goodwill is part of the entity's net unrealized BIG.

Installment Sale

When all or a portion of the purchase consideration is a note issued by the purchaser, a distribution of that note in liquidation of a C corporation (or an S corporation subject to BIG tax on the goodwill) will cause corporate tax to be paid on the final return under Sec. 453B. (2) However, to the extent that consideration for goodwill is allocable to a shareholder, any deferred payment for that goodwill would be eligible for installment reporting by the shareholder.

Sec. 453(h)(1) allows an S shareholder to defer gain attributable to the receipt of certain installment obligations received in a liquidation. However, if a portion of the installment note is in payment for corporate goodwill, the corporate tax imposed on it is not eligible for deferral, creating an incentive to allocate consideration for goodwill directly to the shareholder. This installment-reporting issue should not arise for asset dispositions of an S corporation not subject to the BIG tax, because Sec. 453B(h) permits a distribution of the qualified installment obligation without accelerating gain recognition on the final Form 1120S.

Deemed Asset Sale

In addition to an actual sale of its assets, a corporation may be deemed to have sold its assets. Commonly encountered deemed-sale transactions that may raise a goodwill issue include a (1) liquidation of an operating business, including a conversion of a corporate entity to a proprietorship, partnership or limited liability company (LLC); and (2) qualified stock purchase (QSP) treated as an asset acquisition via a Sec. 338 election.

If a corporation distributes assets in complete liquidation, Sec. 336 provides that the corporation will recognize gain or loss as if the assets were sold to the shareholder who receives the distribution. (3) Such a deemed asset sale may create particularly troublesome goodwill issues, because there is no aggregate sale price to allocate among the seven Sec. 1060 asset categories. In an actual asset sale, there is a fixed pie to divide among all asset categories, including the Sec. 1060 residual goodwill category. In a deemed sale, the IRS and the taxpayer may dispute the total size of the pie, as well as how to allocate it among the seven categories.

A taxpayer who liquidates a corporation (be it an S or a C corporation) should carefully evaluate the factors used to determine the existence of goodwill and whether it belongs to the entity or to the owner. A C liquidation can require payment of a corporate and a shareholder tax; an S liquidation may involve only one level of tax, but the asset distribution will accelerate gain attributable to corporate assets. (4) Taxpayers often ask a tax adviser about the wisdom of converting a corporation to an LLC; the toll charge, if any, imposed on such a conversion depends on the disparity between the value and basis of corporate assets, including goodwill.

A Sec. 338 election allows a QSP of a corporate entity to be treated as if the corporate purchaser first established a new subsidiary that then purchased the business's assets. This election has two forms. Sec. 338(g) respects the seller as having sold stock, but allows the buyer to elect to treat the transaction as an asset purchase. Because the election affects only the buyer's treatment of the transaction, the buyer alone makes the election and bears any tax cost. Sec. 338(h)(10), available when a target is a member of an affiliated group or is an S corporation, results in the seller and buyer treating the transaction as a sale and asset purchase. (5)

One difference between a deemed sale created by a Sec. 338 election and a Sec. 336 liquidation distribution, is that, with the former, the aggregate deemed purchase price is set using the amount paid to purchase the stock, avoiding uncertainty about the total size of the asset pie. A Sec. 338(g) election is rarely advisable when C corporation stock is purchased; the existence of corporate goodwill is one of several factors that would weigh against such an election by the purchaser. Similarly, the net cost (and benefit) of a Sec. 338(h)(10) election can be affected by the existence of corporate goodwill.

C-to-S Conversion

The conversion of a C corporation to an S corporation may also be adversely affected by the existence and value of corporate goodwill. Sec. 1374 imposes a BIG tax on such a corporation, at the maximum 35% rate, if such gains are recognized within 120 months of the conversion. This tax is subject to certain limits; the overall limit equals the net unrealized built-in gain (NUBIG) at the date of conversion. (6) During the recognition period, any S income is subject to the tax, unless the taxpayer can prove otherwise. As BIGs are realized, the NUBIG decreases and reduces the potential for future assessment of the tax. The existence of corporate goodwill will increase the initial NUBIG determination and raise the potential cost of making a C-to-S conversion.

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