Whose Goodwill Is It?

The IRS takes a dim view of transactions where the claim of a personal goodwill sale produces a tax result too good to be true.

Increasing numbers of baby boomers will be looking to retire in the near future. This includes entrepreneurs who have developed successful businesses or professional practices. Many of them will pass their businesses on to their children or other relatives. But for others, retirement means selling the business whose success was due to their hard work and reputation.

If the business was operated as a C corporation, an asset sale will result in the seller paying two levels of tax. Moreover, current tax law provides significant tax benefits to sellers if the sale of business assets can be structured to produce capital gains rather than ordinary income. One way to eliminate the second layer of tax and produce capital gains to the seller is to allocate a portion of the purchase price to the seller's "personal goodwill." Purchasers will also benefit because the amount paid for the personal goodwill can be recovered over 15 years.

Personal goodwill typically arises in the context of a closely-held business or professional practice where the owners are intimately involved in operating the business and have individually developed relationships benefitting the business. It exists when the employee's reputation, expertise, or contacts give value to the business or practice.

Courts have recognized that personal goodwill is an asset that can belong to the owner of a business individually rather than to the business itself—and can therefore be bargained for separately. But the IRS often takes a dim view of transactions where the claim of a personal goodwill sale appears to produce a tax result "too good to be true."

The recent case of Kennedy v. Commissioner illustrates how the lack of proper planning can lead to an IRS victory. Kennedy was the sole shareholder and president of a corporation that provided benefits consulting. Most of the corporation's clients did business with the company because of their loyalty to Kennedy, who had neither an employment contract nor a covenant not to compete with the corporation.

Kennedy decided to sell the business. Twenty-five percent of the purchase price was allocated to consulting services and 75% to Kennedy's personal goodwill. There was no record as to how this allocation was determined. Under a Goodwill Agreement, Kennedy was obligated (1) to convey his personal goodwill to the purchaser; (2) to convey his know-how relating to the business of employee benefits consulting to the purchaser; and (3) to refrain from engaging in employee benefits consulting for a period after the sale, except that he could consult on behalf of the purchaser. The agreement obligated the purchaser to make a series of payments to Kennedy based on a formula determined by business profits from Kennedy's client base.

After the sale, Kennedy worked for the purchaser, during which time his only compensation was from the formula determining his share of business profits. Kennedy treated the payments as proceeds from the sale of personal goodwill, and thus capital gains. The IRS contended that the payments were not for goodwill because, in their view, the customer list belonged to the corporation, not to Kennedy.

The court agreed with the IRS, finding that the payments received by Kennedy were payments for services, not goodwill. The court found it significant that Kennedy provided no appraisal or valuation of the goodwill at the time of the sale, leading the court to suspect a lack of economic reality to the contractual allocation of the payments to goodwill. The court also took into consideration that Kennedy gave the purchaser a valuable promise not to compete and received no wages for his services for 18 months after the sale.

Kennedy shows that facts matter in the tax world. Would Kennedy have won his case with better planning? While one cannot say for certain, it would seem that he would have had a much better chance for success had he received better tax advice.

Any tax advice contained herein was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding U.S. federal, state, or local tax penalties.

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