Transfers of personal goodwill in the sale of a closely held business.

• Author: Koppel, Michael D.

The Tax Reform Act of 1986, P.L. 99-514 (TRA '86), changed the tax landscape in many ways. It created passive activities and at-risk limitations, eliminated many itemized deductions, and changed tax rates. However, from a business acquisition standpoint, the most important change was the repeal of the General Utilities doctrine. Simply stated, the General Utilities doctrine allowed a C corporation to make a tax-free liquidating distribution to its shareholders prior to a sale of the company. This method allowed a C corporation to avoid double taxation on the sale of its assets. The repeal of the General Utilities doctrine was a major reason why so many closely held corporations elected to be S corporations after the enactment of TRA '86.

While many of the reasons why a family business would consider being a C corporation have been eliminated over the years (the deduction of shareholder health insurance, for example), there are still situations in which the limitations on S corporation ownership are an issue. However, businesses, other than personal service corporations, have another reason to consider C corporation status: In a business in which the owner has a strong relationship with the customers, the C corporation structure combined with attribution of personal goodwill to the owner and not the business can result in substantial tax savings when the business is sold.

Example: ABC, Inc., is an insurance agency. As with most businesses, the owner cannot take all the profits as salary because the business needs equity to fund its growth and other needs. J, ABC's sole shareholder, is in the 35% tax bracket. If he takes $100,000 less in salary, he will pay $35,000 less in federal taxes. In the corporation, the first $100,000 of taxable income would have federal taxes of $22,250--a tax savings of $12,750. (State and payroll taxes have been ignored; payroll taxes would generate additional tax savings.)

J is now 60 and is considering retiring within five years. He has discussed the sale of his agency, and his accountant tells him that most sales of insurance agencies are sales of assets, not sales of stock. In their discussion about choice of entity, the accountant reminds J that maintaining the C corporation to build equity could result in double taxation. The accountant has a possible solution, which revolves around who owns the goodwill of the agency.

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