The IRS defines goodwill as “the value of a trade or business based on expected continued patronage of customers due to its name, reputation, or any other factor.” IRS Publication 535: Business Expenses, Chapter 9, Cat. No. 15065Z.
The American Society of Appraisers defines goodwill as: “the intangible asset that arises as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.” And as “that intangible asset that arises as a result of elements such as name, reputation, customer loyalty, location, products and related factors not identified and quantified separately”.
However, capital gains can be separated into personal and business (business) capital gains. Unlike business goodwill, personal goodwill is the intrinsic value of a specific, identifiable person’s services to a business.
The distinction between personal and business goodwill is important insofar as it: (a) saves taxes on business sales; and (b) dividing assets in a marriage.
In divorces, business goodwill is considered marital property and can be divided, while personal goodwill is owned solely by the individual. See: May v. May 589 SE2d 536 (W. Va. 2003) and Ledwith v. Ledwith, 2004 Will. app. LEXIS 488 (October 12, 2004).
When a C Corporation is sold, the company’s goodwill is taxed at the corporate rate (which could be as high as 35%) and then again as a dividend (another 5-15%) when distributed. Not including any state taxes that may be due, a gain of $3,000,000 could result in only $1,500,000 after-tax for a shareholder.
With a few exceptions — sales involving S corporations, partnerships, sole proprietorships, or other pass-through entities — blue sky is taxed only once as a capital asset. Note: Taxed C Corp. may also be incurred with an S Corp, if the S Corp. is not at least ten years old and does not have, for example, adequate incorporated earnings. (See your accountant for the fine details).
In this article we are interested in auto dealer sales and seek to allocate a portion of the proceeds of the sale to personal goodwill because, as CPA Carl Woodward points out in the Spring 2006 issue of “Headlights” from The AutoCPA Group: “For some dealers, much of the overall value of blue sky is due to this personal goodwill.”
The concept of separating goodwill from personal and business distinctions first appeared in the 1986 Nebraska case of Taylor v. Taylor 386 NW2d 851 and later spread to other states. See: Beasley v. Beasley, 518 A.2d 545 (Pa. Super. Ct. 1986); Hanson v. Hanson, 738 SW2d 429, 434 (Mo. 1987); Prahinski v. Prahinski, 75 Md App 113, 540 A2d 833 (1988); In Re Marriage of Talty 166 Ill 2d 232, 652 NE2d 330 (1995) and Martin Ice Cream Co v. Commissioner (110 TC 189 1998).
In 1998, Norwalk v. Commissioner’s memorandum TC 1998-279 held that personal capital gains arise from an intangible asset owned by the individual, not the corporation, and that personal capital gains could be paid to owners because the individuals’ employment contracts expired when sold the corporation.
(Some courts suggest that a seller enter into a non-compete agreement to protect the value of personal goodwill; however, if the personal goodwill portion of the purchase price was paid by a non-compete agreement, it would generate ordinary income instead of capital gains.
Furthermore, while Norwalk possessed personal goodwill is not transferable without a non-compete agreement, in most states and non-compete agreements they are controlled by, among other things, “reasonableness” standards. And, in some states, enforceability is questionable.
Personal goodwill allocations have ranged from 10% to 90% of the total purchase price. In the sale of Tresco Dealerships, Inc., approximately 40% of the goodwill was allocated to the primary dealer as “personal goodwill,” resulting in a tax savings of approximately 27 cents on the dollar.
In one case, a medical practice had a total appraised value of approximately $600,000, with tangible assets of $165,000. The appraiser then allocated $165,000 for equipment and supplies, $35,000 for corporate goodwill, and $400,000 for the doctor’s personal goodwill.
In structuring C corporation asset sales, buyers generally agree to such allocations because they do not have adverse tax consequences.
The IRS assesses personal goodwill in the context of the facts related to each sale and the selling corporation’s contracts, articles, minutes, and more. Did the shareholder have, for example, a non-compete agreement with the company? Was there an employment contract that gave the corporation the benefit of the shareholder’s personal goodwill? Did the buyer think he was buying personal goodwill? Did the seller think he was selling it? (See: Private Letter Judgment 9621002).
This article is limited to discussing “personal goodwill” and is not intended to cover every tax saving method available at a dealer sale. Talk to your accountant and tax attorney about other options, like installment sales and more.
