Personal Goodwill -- A Potential Tax Savings Opportunity
June 28, 2016
By Jordan Amin, CPA, MST and Benjamin Aspir, CPA
Owners of C corporations are confronted with the possibility of double taxation when selling their business as part of an asset sale. The corporation is first taxed at the entity level on the sale of its assets, and the shareholders are subsequently taxed a second time when the corporation liquidates and distributes the sale proceeds. A shareholder may be able to reduce the impact of this double taxation by separating the intangible assets personally owned by the shareholders (i.e. personal goodwill), from those owned by the corporation. This can reduce the amount of gain realized at the corporate level, therefore reducing the total tax liability upon the liquidation of the corporation. The sale of assets owned personally by the shareholders incurs only one level of tax at preferential individual capital gains tax rates.
Goodwill is typically the premium that a buyer is willing to pay above the fair market value of the business assets. Personal goodwill potentially exists when an individual’s reputation, expertise, or contacts contribute significantly to a company’s value and future income stream, whereas corporate goodwill (or “enterprise goodwill”) is derived from characteristics specific to a particular business, regardless of who owns or operates it. Establishing personal goodwill is highly dependent on facts and circumstances. In order to substantiate the existence of personal goodwill it is important to establish the following:
- The company being acquired should be a small, closely held corporation;
- There should be 2 separate sales agreements:
- between the shareholder and buyer (personal goodwill) and
- between the corporation and the buyer (corporation’s assets and goodwill, if any);
- There should be no existing non-compete clause or employment agreement between the seller and the corporation prior to sale;
- There should be no evidence of transfer of personal goodwill to the corporation prior to the sale;
- Subsequent to sale, a non-compete agreement should be signed between the buyer and seller (the agreement should be in effect for several years);
- Selling shareholder should notify their clients of the sale;
- Selling shareholder should be known and recognized in the business community;
- Customers and suppliers deal directly with the selling shareholder;
- The target corporation is dependent upon the selling shareholder's skills, talents, and personal relationships; and
- An independent appraisal of assets and goodwill must be performed.
S corporation shareholders may benefit from the establishment of personal goodwill as well. Although S corporations (since inception) are subject to only one level of taxation (at the shareholder level), selling S corporation shareholders may be able to use allocations to personal goodwill as a method to allocate the purchase price disproportionately with share ownership to reflect a specific owner’s contributions to the business.
As illustrated above, establishing personal goodwill may result in substantial tax savings for taxpayers. However, it is important to note that proper planning utilizing a qualified professional well in advance of the sale is imperative, since personal goodwill has been successfully challenged by the IRS due to improper advice and/or poor planning. If you have any questions, please contact your tax advisor.