Whose goodwill is it?

Author:Reichert, Charles J.

The U.S. District Court for the Eastern District of Washington recently held that goodwill created while a dentist was employed by his solely owned corporation belonged to the corporation and not to him. As a result, the dentist was required to characterize as a corporate dividend rather than a long-term capital gain the amount he received for the goodwill from the sale of his practice.

Goodwill is an intangible asset that represents the residual value of a business after all other tangible and intangible assets have been valued. It is created when a business can attract new customers and retain existing ones or otherwise generate earnings in excess of a fair return on its investment in tangible and other intangible assets. When deciding whether a corporation or its employee owns the created goodwill, the Tax Court, in Martin Ice Cream v. Commissioner, 110 TC 189, stated "personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation." In William Norwalk v. Commissioner, TC Memo 1998-279, a case involving the sale of a CPA firm, the court also stated the goodwill of a professional service corporation belongs to the employees unless the employees "enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships with clients become property of the corporation."

Larry Howard established a dental practice in Spokane, Wash., in 1972. Eight years later, Howard incorporated the practice as Howard Corp., with himself as its sole shareholder, officer and director. He also signed an employment contract that included a noncompete agreement in which he agreed not to have any involvement or financial interest in any business located within 50 miles of Spokane that might compete with Howard Corp. as long as he was a shareholder of that corporation, plus three years after ending his ownership interest. In 2002, the practice was sold to Brian Firm and...

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