In the world of FASB, goodwill is not delineated into personal goodwill and corporate or enterprise goodwill. However, in the tax world, this distinction can be of critical importance and can create significant savings to a taxpayer involved in the sale of a C corporation business.
Many sellers prefer that a transaction be structured as a stock sale, rather than an asset sale, thereby avoiding a built-in gains issue and its related tax liability. Buyers want to do the opposite for a variety of reasons. When a C corporation’s assets are sold, the shareholders must realize the gain and face the issue of double taxation whereby the gain is taxed at the corporate level, and taxed again at the individual level when proceeds are distributed to the shareholders. Proceeds that can be allocated to the sale of a personal asset, such as personal goodwill, avoid the double taxation issue.
The Internal Revenue Service defines goodwill as “the value of a trade or business based on expected continued customer patronage due to its name, reputation, or any other factor.”1 Recent Tax Court decisions have recognized a distinction between the goodwill of a business itself and the goodwill attributable to the owners/professionals of that business. This second type is typically referred to as personal (or professional) goodwill (a term used interchangeably in tax cases).
Personal goodwill differs from enterprise goodwill in that personal goodwill represents the value stemming from an individual’s personal service to that business, and is an asset owned by the individual, not the business itself. This value would encompass an individual’s professional reputation, personal relationships with customers or suppliers, technical expertise, or other distinctly personal abilities which provide economic benefit to a business. This economic benefit is in excess of any normal return earned on other tangible or intangible assets of the company.
In Martin Ice Cream Co. v. Commissioner (“Martin”)2, the Tax Court ruled that intangible assets embodied in the shareholder’s personal relationships with key suppliers and customers were not assets of the shareholder’s corporation because there was no employment contract or non-competition agreement between the shareholder and the corporation. In this case, the shareholder/owner, Arnold Strassberg, had developed personal relationships with his customers over a period of approximately 25 years. During this time, Mr. Strassberg was instrumental in the design of new ice cream packaging and marketing techniques. In 1974, the founder of Haagen-Dazs (a large ice cream manufacturer) asked Mr. Strassberg “to use his ice cream marketing expertise and relationships with supermarket owners and managers to introduce Haagen-Dazs ice cream products into supermarkets.”3
The underlying question in the Martin case involved the tax treatment of a 1988 split-off of Mr. Strassberg’s portion of the business from the rest of the company. Arnold Strassberg had an oral agreement to distribute Haagen-Dazs products, and his portion of the business focused on the large supermarket customers, with whom he had developed personal relationships throughout his career. Arnold Strassberg’s son Martin, the other shareholder of Martin Ice Cream Co. (“MIC”), preferred instead to focus on the small store business. Strassberg Ice Cream Distributors, Inc. (“SIC”), a subsidiary entirely related to Arnold Strassberg’s side of the business that serviced the large supermarkets, was split-off from the rest of the company. Arnold Strassberg became the sole shareholder of SIC, and the assets of SIC were subsequently sold to Haagen-Dazs.4
The Tax Court held that Arnold Strassberg’s oral agreement for distribution with Haagen-Dazs and his personal relationships with customers were never corporate assets of MIC, and therefore could not have been transferred to SIC in the split-off. Prior to the sale to Haagen-Dazs, Arnold Strassberg was the sole owner of those intangible assets because he had never entered into an employment or non-competition agreement. The Tax Court concluded,
“Accordingly, neither any transfer of rights in those assets to SIC or other disposition to Haagen-Dazs is attributed to petitioner [Martin Ice Cream Co.]”5
While the Martin case does not provide specific methodology for valuing personal goodwill, it does lend guidance to the issue of identification of personal goodwill apart from corporate goodwill. Following the Tax Court’s approach, the process of recognizing personal goodwill would consider the following issues:
- Do personal relationship exist between customers or suppliers and the owner/manager of the business?
- Do these relationships (customer or supplier) persist in the absence of formal contractual obligations?
- Does the owner/manager’s personal reputation and/or perception in the industry provide an intangible benefit to his business?
- Are the practices of the owner/manager innovative or distinguishable in his or her industry, such that the owner/manager is regarded as having added value to that particular industry?
- With respect to the above factors, is the owner/manager currently under any employment agreement or covenant not to compete with the business?
The existence of personal goodwill apart from corporate goodwill was also recognized in Norwalk v. Commissioner (“Norwalk”).6 The Norwalk case centered on the tax implications of the liquidation and distribution of assets of an accounting firm (C corporation). The two shareholders of the firm elected to terminate the company and to distribute its assets because the business was not profitable. The IRS maintained that the firm had realized a gain on the liquidation of its goodwill, and that the shareholders had realized a capital gain from the distribution of goodwill from their accounting firm to them. Although the shareholders had employment agreements with the firm prior to its dissolution, these agreements expired at the time of the liquidation.7
The Tax Court found that the liquidation was not taxable because the employment agreements with the shareholders had expired. With no enforceable contract in place to restrict the activities of the accountants, any personal goodwill of the shareholders was not an asset belonging to the corporation. Therefore the distribution of the client base to the shareholders did not result in a taxable event to either the firm or the shareholders.
Citing MacDonald v. Commissioner8, the Tax Court in Norwalk stated:
“We find no authority which holds that an individual’s personal ability is part of the assets of a corporation by which he is employed where, as in the instant case, the corporation does not have a right by contract or otherwise to the future services of the individual.”9
Although both Norwalk and Martin clearly recognize the concept of personal goodwill, neither provides a definitive answer as to its quantification. Because personal goodwill is considered to be the value of the services of a particular individual to a firm, the issue often arises in the context of professional practices. With respect to professional practices, Lopez v. Lopez10 suggests several factors that should be considered in the valuation of professional (personal) goodwill:
- The age and health of the individual;
- The individual’s demonstrated earning power;
- The individual’s reputation in the community for judgment, skill, and knowledge;
- The individual’s comparative professional success
- The nature and duration of the professional’s practice as a sole proprietor or as a contributing member of a partnership or professional corporation.
Should a seller be contemplating an asset sale of his or her C Corporation, and there is an embedded gain involved, the possibility of allocating a portion of the purchase price to personal goodwill should be considered. However, the idea must have a basis in reality. The best case scenario is when the shareholder/manager has an excellent professional reputation and close contact with customers and suppliers.
While the transaction price, including any intangible assets, is often negotiated between the buyer and seller, it is highly recommended that a professional appraisal be obtained to allocate the appropriate portion of the transaction to personal goodwill.
- Non-Compete Agreements: Valuation Issues in GAAP and Tax Engagements
- Mercer Capital’s Transaction Advisory Services
1 IRS Publication 535: Business Expenses, Ch. 9, Cat. No. 15065Z
2 Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998).
6 Norwalk v. Commissioner, T.C. Memo 1998-279.
8 MacDonald v. Commissioner, T.C. 720,727 (1944).
9 Norwalk v. Commissioner, T.C. Memo 1998-279.
10 In re Marriage of Lopez, 113 Cal. Rptr. 58 (38 Cal. App. 3d 1044 (1974).