In the circumstance where substantially all of the assets of a closely-held C corporation are being sold, the shareholder of the seller may desire to receive part of the purchase price directly from the buyer for his or her personal goodwill. The result is beneficial to both the buyer and the selling shareholder. The buyer gets to amortize the amount paid for the goodwill ratably over fifteen (15) years, and the shareholder enjoys two tax advantages, namely he or she gets capital gain treatment on the amount received for the goodwill and he or she avoids the corporate level tax. This approach works provided certain facts exist:
- The selling shareholder has created personal goodwill;
- The selling shareholder has the ability to take the personal goodwill with him or her to another company and has the ability to compete with the corporation;
- There is no contractual arrangement limiting the selling shareholder’s ability to use the personal goodwill in the pursuit of work for a business competitor or the ability to sell it to a business competitor; and
- The amount of the sale proceeds allocated to the personal goodwill is reasonable.
The leading cases on personal goodwill include: Martin Ice Cream v. Commissioner, 110 TC 189 (1998), and Norwalk v. Commissioner, 76 TCM 208 (1998). Commentators often refer to these cases as foundational in this area of tax law.
In 2011, it appeared using personal goodwill as an asset in the sale of a business may have been curtailed a bit. In Howard v. US, 108 AFTR.2d 2011-5993 (Ninth Cir., August 29, 2011), affg 106 AFTR.2d 2010-5533 (DC Wash., July 30, 2010), the court was presented with a case involving a dentist from Spokane, Washington. Dr. Howard began practicing dentistry in 1972. In 1980, he incorporated his dental practice and it remained a C corporation for its duration. Dr. Howard was the only shareholder, director and officer of the corporation. His attorney prepared, along with the basic incorporation documents, an employment agreement between Dr. Howard and the corporation. In that agreement, it provided that Dr. Howard could not, during his employment with the corporation and for a period of three (3) years thereafter, compete with it in the practice of dentistry.
Twenty-two (22) years later, Dr. Howard decided to sell the assets of the corporation. Once he learned about the tax consequences of selling the assets of a C corporation, his accountant likely suggested an allocation of some of the purchase price to personal goodwill would be beneficial. It appears that nobody remembered the non-competition provision contained in the employment agreement or considered that it may have an impact on the sale of personal goodwill. The purchase price for the business assets was $613,000. It was allocated as follows:
$549,900 Personal Goodwill
$ 16,000 Dr. Howard’s Non-Compete Covenant
$ 47,100 The Assets of the Corporation
On audit, the Service re-characterized the amount allocated to personal goodwill as corporate goodwill. Consequently, the corporation had income from the sale of the goodwill, and Dr. Howard had dividend income resulting from the distribution of the sale proceeds he received from the corporation. Dr. Howard paid the deficiency, and filed a claim with the IRS for refund. When his claim for refund proved to be unsuccessful, he sued for refund in the Federal District Court for the Eastern District of Washington. Dr. Howard argued that the purchase and sale agreement was dispositive of the issue – the parties, acting at arms length, allocated $549,900 of the sale proceeds to personal goodwill. The Service, of course, responded by displaying for the judge’s eyes the non-competition provision that was contained in Dr. Howard’s employment agreement, and argued it voided the parties attempt to buy and sell personal goodwill.
Dr. Howard then got quite creative. He asserted that, as the sole shareholder, officer and director of the corporation, he terminated the non-competition provision by entering into the purchase and sale agreement. Good try! The astute attorney for the government pointed out that, even if Dr. Howard’s assertion was correct, termination of the non-competition provision did not change the character of the goodwill generated for the twenty-two (22) years before the termination – it was and still is corporate goodwill.
Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "Tax Law Update for Family Law Practitioners," Oregon State Bar - Family Law Section 2019 Annual ConferenceSunriver, OR, 10.11.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationNew York, NY, 10.20.19-10.25.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," Oregon Society of Certified Public Accountants (OSCPA) 2019 Northwest Federal Tax ConferencePortland, OR, 10.28.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationSan Francisco, CA, 11.10.19–11.15.19
- "The Oregon Corporate Activity Tax," Oregon Society of Certified Public Accountants (OSCPA) 2020 OSCPA State & Local Tax ConferencePortland, OR, 1.6.20