Tax Opportunities Related to Personal Goodwill

Sales transactions involving closely held businesses can be complex, and there are potential benefits to both buyers and sellers depending on how such transactions are structured.

 This article explores the concept of personal goodwill in sales transactions and how proper structuring can result in favorable tax treatment.    

Personal goodwill exists when a shareholder’s reputation, expertise, or relationships contribute significantly to a company’s value and future income stream. Personal goodwill usually manifests itself in the form of close relationships with customers and/or suppliers. These established relationships are often critical to a business’ success and therefore should be considered if an entity is sold. 

When a business is acquired in a transaction that is structured as an asset purchase for tax purposes, the buyer and seller are required to allocate the purchase price to the tangible and intangible assets acquired. If a portion of the purchase price can be allocated to personal goodwill of the selling shareholder, the buyer will benefit from future amortization of that goodwill. From the seller’s point of view, the more sales proceeds that can be allocated to  personal goodwill and taxed to the individual shareholder, the less will be subject to the less-favorable corporate tax rules (i.e., income that is taxable first to the corporation and then to the shareholder(s)). 

Because of this tax treatment, IRS has a history of challenging the allocation of purchase price to personal goodwill. As a result, the parties should have prepared a well-reasoned valuation by an experienced third-party appraiser to document their assumptions and conclusions, and ultimately support the allocations.   

Demonstrate that Personal Goodwill Exists Separate from Corporate Goodwill

Establishing personal goodwill exists separate from corporate goodwill is the first step in this type of analysis. The existence of personal goodwill can be substantiated by certain facts such as client relationships, relevant credentials of the key individual, or reputation, among other factors. A taxpayer must prove that the value is dependent on the key individual, as opposed to the company’s intangibles and operations. As a result, personal goodwill often arises in professional practices or closely held businesses where the efforts of a single individual may have more of an impact.  

The Martin Ice Cream case is one of the seminal cases in the area of personal goodwill. Arnold Martin, a shareholder of Martin Ice Cream Company (MIC), exchanged his stock in the company for ownership in a subsidiary called Strassberg Ice Cream Company (Strassberg), which was MIC’s supermarket distribution business. Shortly thereafter, Pillsbury Co. purchased certain assets of Strassberg and paid Mr. Martin $1.2 million for seller’s rights. IRS contended that all of the assets purchased were corporate assets. The Tax Court found, however, that the assets were, in fact, personal because the success of Strassberg’s business was contingent on the personal relationships of Mr. Martin. Also of importance was that during his tenure at Martin Ice Cream, Mr. Martin never had an employee contract or non-compete agreement.  

Separate Personal Goodwill from Business Assets

Once the existence of personal goodwill is established, the taxpayer must personally hold the right to sell goodwill. The taxpayer cannot have previously transferred the goodwill-related assets to the company. Once a shareholder transfers his personal goodwill through an employee contract or non-compete agreement, the existing goodwill then belongs to the corporation. If preexisting contracts exist between the taxpayer and company before the transaction, then the existence of personal goodwill is voided. 

In the case of Howard v. U.S., a practicing dentist incorporated his sole proprietorship and entered into an employment contract and non-competition agreement with his business. Later, Mr. Howard sold his practice. He allocated a significant portion of the sale price to personal goodwill. IRS argued that the employment agreement made the personal goodwill an asset of the company and, as a result, proceeds made to Mr. Howard for personal goodwill reflected a dividend payment from the corporation. The Court of Appeals for the 9th Circuit upheld IRS’s re-characterization of the sale payment and noted that while personal goodwill had existed in the form of personal relationships, the goodwill no longer belonged to Mr. Howard when he conveyed control to his business.   

Structure the Transaction Appropriately

Even in cases where personal goodwill was present, the Tax Court has ruled against taxpayers due to a lack of supporting contractual documentation or an appraisal. It is important that the personal goodwill be clearly identifiable in the purchase agreements so that the intention of the parties is known. 

Likewise, in the case of James P. Kennedy, the Court found that even though personal goodwill existed, it was not enough to conclude that the goodwill was sold. In many cases, the contractual allocation of a payment to goodwill is critical in determining whether the payment was, in fact, for goodwill. Observing formalities and maintaining extensive documentation will bolster the credibility of this allocation. 

Consider Hiring an Experienced Appraiser

Because IRS has had success in challenging poor or inconsistent fact patterns, having a third-party appraisal can help the taxpayer withstand scrutiny and substantiate a claim of personal goodwill. When executed correctly, appraisals can play a critical role in securing this advantageous tax outcome for both the buyer and seller.