My September 2011 Blueprint for Wealth column in the Washington Business Journal features a discussion on the tax treatment of "personal goodwill."
When you go to sell your business, a key component of the price you will receive is the goodwill of the business. As a seller, you generally want as much of the sales price treated as goodwill, so you can generate long-term capital gains on the sale and be taxed at favorable rates. If the business is conducted by a C corporation, the treatment of goodwill in the sale of assets is not so favorable; it is treated like any other asset and taxed at the highest corporate rate. Moreover, the shareholders must pay tax on any distributions from the C corporation in the form of dividends, resulting in double taxation.
To avoid this adverse treatment, some taxpayers have argued successfully that the goodwill being sold does not belong to the corporation. Rather, it is “personal goodwill”, which is owned by the individual owner and service provider. So, when the business is sold, you may try to sell your personal goodwill to the buyer, and have your C corporation sell its other assets in the same transaction. In this way, you are taxed at favorable long-term capital gains rates on the goodwill you are selling, and the corporation would pay tax on the gain generated from other assets.
What is Goodwill? The courts have defined “goodwill” as the expectancy of continued patronage, for whatever reason. It is the probability that old customers will return to the old place without “contractual compulsion.” In other words, “goodwill” represents the general ability of the business to continue generating income into the future based upon its past practices.
Goodwill can be attributed to an individual employee or to a company, depending on the employment relationship between the two. There generally is no corporate goodwill where the business of a corporation is dependent exclusively on its key employees, unless they enter into a covenant not to compete with the corporation or other agreement where their personal relationships with clients become property of the corporation. In the absence of a covenant not to compete and employment agreement with the corporation, key employees arguably have personal goodwill than can be sold in a transaction with a buyer. As noted, this can generate favorable tax results to the owner-employees of a C corporation that is selling its business.
Usually, the buyer requires the selling corporation’s employees to enter into covenants not to compete with the buyer as a condition of acquiring their personal goodwill. In that event, an additional concern is how much of the purchase price to allocate to personal goodwill (which is taxed at favorable long-term capital gains rates) versus a non-compete covenant (which is taxed less favorable ordinary income rates).
Calling Dr. Howard! A recent tax case out of Washington State illustrates the personal goodwill issue. Dr. Howard was the sole shareholder of a corporation that conducted his dentistry practice for 22 years. He had an employment agreement and a covenant not to compete with his corporation from its inception, until the practice was sold in 2002. The covenant not to compete precluded Dr. Howard from working for a competing dentistry practice within 50 miles of the corporation’s offices for three years following his termination of employment. When he sold his practice to Dr. Finn and Dr. Finn’s corporation, Dr. Howard structured the transaction to specifically include a provision referring to the sale of his personal goodwill for a portion of the proceeds. The IRS challenged Dr. Howard’s treatment of the personal goodwill, claiming that it belonged to the corporation and should have been taxed inside the corporation.
The Eastern District Court in Washington State found that the goodwill belonged to the corporation, not Dr. Howard. The court based its findings primarily on the fact Dr. Howard was continuously subject to an employment agreement and covenant not to compete during his affiliation with the corporation that basically caused all of his personal goodwill generated during his employment to be owned by the corporation. In essence, he had assigned all rights to the income generated from his personal relationships to the corporation when he entered into the agreements. The court also found it important that the corporation generated all of the income from and paid taxes on the services rendered by Dr. Howard.
Lessons Learned. If you are trying to sell the businesses of your C corporation, you may want to classify a portion of the purchase price as personal goodwill. To sustain the tax treatment as personal goodwill, you probably should avoid entering into a covenant not to compete and employment agreement with your own corporation before selling its business. Moreover, you should involve a tax attorney, CPA and valuation expert to properly structure the transaction and allocate the purchase price across all assets, including tangible assets, corporate goodwill, personal goodwill and any non-compete covenant the buyer asks you to sign.