The presence of personal goodwill in a business transaction is important. Personal goodwill can provide tax-efficient opportunities in a merger and acquisition transaction by alleviating corporate tax upon the sale.
The Internal Revenue Service defines goodwill as “the value of a trade or business that is attributable to the expectancy of continued customer patronage due to its name, reputation, or any other factor.”
There are two types of goodwill – business goodwill and personal goodwill. Business goodwill is associated with the assets of a business. Personal goodwill represents the value stemming from an individual’s personal service to that business, and is an asset owned by the individual, not the business itself. This economic benefit is in excess of any normal return earned on other tangible or intangible assets of the company.
Personal goodwill derives from the past, present, or future expected efforts and characteristics of an individual or group of individuals. The potential sources of personal goodwill can be loosely categorized into four main groups:
- Relationships - Personal relationships with customers, suppliers, employees, or even competition may enhance the earning power of a company.
- Skill -
Personal goodwill may exist as a skill.
- Knowledge -
Knowledge can be defined as the unique possession of information, or the unique ability to analyze information, by and within an individual.
- Reputation - The reputation of a company may derive in whole or in part from personal goodwill and typically derives from relationships, skill, or knowledge.
In a corporate transaction involving a C-Corporation, the differentiation between personal goodwill and business goodwill results in significantly different tax treatment upon disposition. A disposition of the assets of the C-Corporation will result in a tax on the gain on the sale of the assets at the corporate level and another tax as a dividend at capital gains rates on the distribution of the proceeds. This presents a conflict between buyers and sellers of C-Corporations.
Buyers desire to buy assets of a business because the tax basis of the assets is stepped up to fair market value for post-acquisition depreciation and amortization, enhancing post acquisition cash flow. Sellers, on the other hand, desire to sell stock that results in one level of tax at the capital gains rate.
Business goodwill sold by a C-Corporation is subject to the double tax. However, personal goodwill that is attributable to a shareholder is taxable to the individual as a capital gain.
The landmark court case for personal goodwill is Martin Ice Cream Company v. Commissioner, 110 T.C. No. 18 (1998). In the Martin case, the Tax Court ruled that intangible assets embodied in the shareholder’s personal relationships with key suppliers and customers were not assets of the corporation because there was no employment contract or non-competition agreement between the shareholder and the corporation.
The process of recognizing personal goodwill, that stemmed from the Martin case considers the following issues:
- Do personal relationships exist between customers or suppliers and the owner/manager of the business?
- Do these relationships (customer or supplier) persist in the absence of formal contractual obligations?
- Does the owner/manager’s personal reputation and/or perception in the industry provide an intangible benefit to his business?
- Are the practices of the owner/manager innovative or distinguishable in his or her industry, such that the owner/manager is regarded as having added value to that particular industry?
- Is the owner/manager currently under any employment agreement or covenant not to compete with the business?
On the other hand, in 2010 in James E and Joan P. Kennedy v. Commissioner, T.C. Memo 2010-206 (Sept 22, 2010), the Court held that the annual payments received were not for his personal goodwill because Kennedy: 1) worked for the Company for five years; 2) received little compensation for his services for 18 months; and 3) he agreed not to compete with the Company for a five year period. The IRS took the position that the allocations were tax-motivated and not supported by the facts. The Court agreed.
More recently, there have been two tax court cases involving personal goodwill. In Bross Trucking, Inc. v. Commissioner, T.C. No. 7710-11, T.C. Memo 2014-107, June 5, 2014), the sons of the owner of a business formed a new company in the same line of business. The subject company had some regulatory issues that impacted the business’ ability to continue to operate. The IRS asserted that the distribution of appreciated property, business assets to the owner, who gifted the assets to his son, resulted in corporate tax, gift tax and penalties. The Court found that the assets were personal goodwill and owned primarily by Bross personally and not the property of the corporation. In this matter, the Court reasoned that 1) all of the goodwill used by the company was a personal asset of Bross; the company did not have any goodwill; 2) Bross never transferred his goodwill to the company; 3) No intangible assets were transferred from the company to the new company formed by the sons; and 4) Bross was free to compete against the new company. Since the assets were not business goodwill there was no corporate tax or penalties owed.
In Estate of Franklin Z. Adell, T.C. Memo 2014-155 (Aug 4, 2014), the decedent owned all of the shares of STN stock. His son Kevin was the president of STN and was instrumental in the development of the business. The business was valued using a discounted cash flow method and then the value was reduced by an economic factor for the son’s personal goodwill because the Company’s revenue was dependent upon the son’s relationships. The son had no employment agreement with the Company and was not subject to a covenant not to compete. The tax court agreed concluding that because the son was free to leave the company and compete against it, the large economic factor was warranted. The economic factor had an enormous impact on the value of the company because it reduced the value of the assets by about 70% from what it would’ve been.
These cases reflect the importance of the characterization of goodwill as personally owned rather than as a business asset since it can have important tax implications. Personal goodwill does exist and it can be valued and the value may be significant in a merger and acquisition situation because of the tax implementations.