4 Questions to Assess ‘Personal Goodwill’ in a C Corporation Asset Sale
With M&A activity on the rise, corporations may be looking for the most tax-advantageous exit strategy. Even if selling appears attractive, corporations with asset gains face the double-taxation trap at both the corporate and shareholder levels. However, a lesser-known area of tax law could greatly ease this burden in a C corporation asset sale.
On an asset sale of a corporation’s business, a large portion of the sale price is typically allocated to corporate goodwill, which represents the value and degree of sales and earnings growth. The problem is that the sale of corporate goodwill will not only create a corporate-level taxable gain, but the after-tax proceeds will be taxed again upon distribution to the shareholders as a dividend (taxed up to the 20% federal rate, plus a 3.8% net investment income tax, plus the shareholder’s applicable state tax rate).
This double-tax trap should raise the question of whether the goodwill, or some part of it, was really generated by an owner (such as the founder or current president) who was instrumental in helping the growth and performance of the company. If a case exists for personal goodwill, then a separate transaction can be created between the purchaser and the individual for that goodwill piece. In such a scenario, only one level of gain is taxed to the individual (the goodwill gain), and the second-level dividend tax is alleviated.
Adopting the tax position of personal goodwill requires strong evidence and a high degree of substantive facts. Based on case law — notably, 1998’s Martin Ice Cream Co. v. Commissioner — the following questions help assess the technical merits of a personal goodwill claim.
- Did the owner have a noncompete or employment agreement?
The shareholder (“owner”) must not have a noncompete or employment agreement with the company if trying to assert personal goodwill. The presence of such agreements would suggest the owner’s contributions toward sales and earnings growth belonged to the company. The absence of such agreements shows evidence of individual autonomy.
- To what extent did the owner drive new business?
Because it speaks to substance, this question is even more important. In assessing the owner’s material participation in generating new business, it’s critical to review how much the business’s growth was directly attributable to the owner’s self-innovative marketing strategies versus the corporation’s larger team effort. In Martin Ice Cream, for example, the owner employed unique packaging schemes that were the driving force in securing new business relationships. On the other hand, if an owner merely followed a corporate-generated policy of marketing techniques and best practices, it presents a weaker case of unique personal contribution.
- Does the owner possess a strong industry reputation?
Industry reputation is an important consideration, but it should not be confused with good salesmanship. The owner should possess well-established industry expertise and a distinct level of recognition that has led to generating new business. Factors to consider as evidence could include owner mentions in publications, media interviews, requests to speak at large events, or activity in reputable industry groups.
- Are there two separate asset purchase agreements?
Having distinctly separate agreements between the corporate asset sale and the personal goodwill offers strong proof of separation between the corporation and the individual. This step would require a carve-out of the purchase price to allocate between the two agreements. For the personal goodwill sale agreement, it should be signed by the individual alone and not by an officer of the company. Once again, a clear separation is needed between the owner and the corporation. In challenging a personal goodwill position, the IRS will look for a corporate connection that may tarnish the taxpayer’s argument of separate value.
Start with a valuation
How a potential seller answers the preceding questions will help determine whether sufficient grounds exist for a personal goodwill case.
If a taxpayer concludes that the above tests are satisfied, assessing the fair market value of personal goodwill is a critical next step. However, simply coming up with a number out of thin air is not advisable and likely not sustainable upon challenge. The prudent approach would be to engage an independent third-party valuation group to assess the value of the goodwill between the corporation and the owner.
The right professional team will provide insights for structuring a corporate sale in the most tax-efficient way, so there will be plenty of savings left to celebrate — maybe over ice cream.
Business Tax Quarterly - Spring 2019