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By Edward L. Fixen
There are many potential strategies to reduce and minimize tax liability when selling a business. One strategy that is often overlooked is the use of “personal” goodwill for the benefit of both parties in an acquisition. Personal goodwill is distinct from conventional corporate goodwill which is more commonly understood and utilized. Naturally, every business owner should consult their accountant when selling a business to understand the tax implications and develop a plan to minimize taxes where possible. This article identifies and discusses personal goodwill as a simple strategy that should be explored with your accountant when buying or selling a business.
Personal goodwill is generally viewed as some combination of the reputation, personal relationships with customers/suppliers and expertise of the shareholder. When selling a business, the IRS requires that the purchase price be allocated amongst the various asset classes that comprise a business. Overall, the asset classes consist of tangible and intangible assets. Tangible assets consist of cash, accounts receivables, furnishings, fixtures, equipment, inventory, buildings, land, etc. Intangible assets consist of intellectual property such as trademarks, copyrights and patents, non-compete agreements, customer lists and goodwill to name some of the more common intangible assets. The purchase price of the business being acquired must be allocated amongst these tangible and intangible assets for the purpose of determining tax treatment for both the seller and buyer.
For example, the allocation of a portion of the purchase price to a non-compete is typically treated as ordinary income to the seller for tax purposes and amortized by the buyer over a 15 year period. On the other hand, corporate goodwill held by the seller for more than one year is treated as a more favorable capital gain tax for the seller and amortized over a 15 year period for the buyer. For the obvious tax benefits, goodwill is preferred by sellers to the maximum extent possible. Fortunately, in many cases “personal” goodwill is another option in addition to the conventional “corporate” goodwill. The primary advantage of personal goodwill is that the seller benefits from the more favorable capital gains rate for that portion allocated to personal goodwill, without any cost to the buyer, so both parties benefit.
In a 1998 decision known as Martin Ice Cream v. Commissioner, a taxpayer successfully argued that the goodwill of a corporation can be classified into goodwill owned by the corporation and goodwill owned by the shareholder(s). The taxpayer convinced the Tax Court that the corporation’s success was largely based on the personal reputation and the industry contacts of the owner, that most of the goodwill was personal to the owner and had not been transferred to the corporation. Based on this dual classification of goodwill, the owner’s personal goodwill is a separately saleable asset that avoids double tax in a ‘C’ corporation and is subject to favorable capital gains tax rates, currently 15% federal rate versus rates up to 35% for ordinary income. The use of personal goodwill was successful in another 1998 case, Norwalk v. Commissioner. This case involved the liquidation of an accounting practice. The Tax Court applied the theory of personal goodwill and found that the intangible asset attributable to the client relationships was the property of the individual owners and not the corporation.
Case law has shown that the courts recognize personal goodwill as an asset of the shareholder/owner that is separate and distinct from corporate assets. The best case is one where the customers and suppliers perceive themselves as dealing with the individual owner rather than with the legal entity. A service business is most likely to support this position, although the Martin Ice Cream case demonstrates it can apply to other types of businesses. In fact, my company recently brokered the sale of a manufacturing business where both the buyer and seller’s accountants agreed that personal goodwill was both appropriate and beneficial to both parties. If personal goodwill is included in the purchase price allocation, it would be advisable to have a business valuation expert estimate the value of the goodwill for tax reporting purposes.
Of course, every acquisition is unique and requires analysis and advice from your accountant and/or professional advisors regarding the potential use of personal goodwill. Just make sure it isn’t overlooked.
Author: Mr. Fixen is a Certified Business Appraiser (CBA) and Certified Business Broker (CBB). Mr. Fixen is the President of BusinessQuest, a business valuation and M&A brokerage firm serving small & mid-size, privately-held businesses throughout California. Ed can be reached at (909) 636-9827 or [email protected].
