The IRS defines goodwill as “the value of a trade or business based on the customer’s expected continued patronage due to name, reputation, or any other factor.” IRS Publication 535: Business Expenses, Chapter 9, Cat. No. 15065Z.
The American Society of Appraisers defines goodwill as: “that intangible asset that arises as a result of name, reputation, customer loyalty, location, products, and similar factors that are not separately identified.” And as “that intangible asset that arises as a result of elements such as name, reputation, customer loyalty, location, products and related factors not identified and quantified separately.”
However, goodwill can be divided into personal and business (business) goodwill. Unlike corporate goodwill, personal goodwill is the intrinsic value of the services of a specific and identifiable person to a company.
The distinction between personal and business goodwill is important insofar as: (a) tax savings on the sale of businesses; and (b) divide the assets in a marriage.
In divorces, the business goodwill is considered marital property and can be divided, while the personal goodwill is the sole property of the individual. See: May v. May, 589 SE2d 536 (W. Va. 2003) and Ledwith v. Ledwith, 2004 Va. App. LEXIS 488 (October 12, 2004).
When a C corporation is sold, the company’s goodwill is taxed at the corporate rate (which could go up to 35%), and then again as a dividend (another 5 – 15%) when distributed. Not including any state taxes that may be owed, a profit of $ 3,000,000 could result in only $ 1,500,000 after taxes for one shareholder.
With a few exceptions, sales involving S corporations, partnerships, sole proprietorships, or other pass-through entities, Blue Sky is taxed only once as a capital asset. Note: C Corp. taxed with an S Corporation can also be incurred if the S Corporation is not at least ten years old and does not have, for example, adequate built-in earnings. (Visit your accountant for details.)
In this article, we are interested in auto dealership sales and are considering allocating a portion of the sale proceeds to personal goodwill because, as CPA Carl Woodward notes in the Spring 2006 publication of “Headlights Front “AutoCPA Group:” For some dealers, much of the total value of the blue sky is due to this personal goodwill. “
The concept of separating goodwill with personal and business distinctions first appeared in the 1986 Nebraska case of Taylor v. Taylor 386 NW2d 851 and later spread to other states. See: Beasley v. Beasley, 518 A.2d 545 (Pa. Super. Ct. 1986); Hanson v. Hanson, 738 SW2d 429, 434 (Mo. 1987); Prahinski v. Prahinski, 75 Md App 113, 540 A2d 833 (1988); In Re Marriage of Talty 166 Ill 2d 232, 652 NE2d 330 (1995) and Martin Ice Cream Co v. Commissioner (110 TC 189 1998).
In 1998, Norwalk v. Commissioner TC’s memorandum 1998-279 held that personal goodwill comes from an intangible asset that is owned by the individual, not the corporation, and that personal goodwill could be paid to owners because individuals’ employment contracts they expired when the corporation was sold.
(Some courts suggest that a seller enter into a non-compete agreement to protect the value of personal goodwill; however, if the personal goodwill portion of a purchase price were paid by a non-compete agreement, it would generate revenue in place of capital gains.
Additionally, while Norwalk maintained personal goodwill it is not transferable without a non-compete covenant, in most states and the Reexamination of Contracts, non-compete agreements are controlled, among other things, by standards of “reasonableness” . And, in some states, the applicability is questionable.
Personal goodwill allocations have ranged from 10% to 90% of the total purchase price. In the Tresco Dealerships, Inc. sale, approximately 40% of the capital gain was allocated to the dealer principal as “personal capital gain,” resulting in a tax savings of approximately 27 cents on the dollar.
In the event that a medical practice had a total appraised value of approximately $ 600,000, with tangible assets of $ 165,000. The appraiser then allocated $ 165,000 to equipment and supplies, $ 35,000 to corporate goodwill, and $ 400,000 to the physician’s personal goodwill.
When structuring the asset sales of “C” companies, buyers often agree to such allocations because they do not have adverse tax consequences.
The IRS evaluates personal goodwill in the context of the facts related to each sale and the contracts, articles, minutes, and so on of the selling corporation. Did the shareholder, for example, have a non-compete agreement with the corporation? Was there an employment contract that gave the corporation the benefit of the shareholder’s personal goodwill? Did the buyer think they were buying personal goodwill? Did the seller think he was selling it? (See: Resolution of private letter 9621002).
This article is limited to discussing “personal goodwill” and is not intended to cover all of the tax saving methods available at a dealership sale. Talk to your accountant and tax attorney about other options, like installment sales and more.