Goodwill is an intangible asset representing the value of a business beyond its tangible book value.  Investment management businesses generally have plenty of value beyond their tangible book value.  Therefore, they have lots of goodwill that can be attributed to factors like the firm’s client relationships, the recurring revenue model, brand recognition, or employee expertise.

The concept of goodwill can be further divided into “personal” goodwill and “enterprise” goodwill.

Personal goodwill represents the portion of goodwill that can be attributed to an individual as a result of their personal relationships, individual expertise, and personal reputation.

Enterprise goodwill is the portion of goodwill that can be attributed to the enterprise as a result of factors like brand recognition, client contracts, proprietary processes and systems, team expertise, and the like.

Goodwill and the distinction between personal and enterprise goodwill can have important economic consequences in RIA transactions and disputes.

Tax Advantages in a Transaction

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 or professionals of that business.  This second type is typically referred to as personal (or professional) goodwill (terms that are used interchangeably in tax cases).

Generally, personal goodwill is recognized by the Tax Court when it arises from an individual’s personal reputation, skills, or relationships.  Personal goodwill is considered to be an asset owned by the individual, not the business itself, and is recognized as a salable asset by the US Tax Court.

The Tax Court’s recognition and treatment of personal goodwill as a salable asset can be particularly relevant in the wealth management industry.  Consider the situation of a typical wirehouse adviser.  Generally, such advisers don’t technically own an interest in their book of business (owned by the wirehouse) but nevertheless have longstanding personal relationships with their clients.  If such an adviser were to leave the wirehouse to join an independent RIA, there is often an expectation that some portion of clients will follow the adviser to his new firm.  Because of this expectation, such deals are often structured to look more like acquisitions than hirings, even though the adviser doesn’t technically have a legal interest in a business to sell.

Typically, deals such as this will include upfront and/or contingent consideration tied to the amount of revenue that the adviser is able to transfer to the new firm.  By structuring these transactions as a purchase of the adviser’s personal goodwill, the consideration received by the adviser may qualify for capital gains tax rates as opposed to ordinary income, resulting in significant tax savings for the adviser.

In order to justify the allocation to personal goodwill, it’s generally advisable to obtain an independent appraisal of the adviser’s personal goodwill in advance of a transaction.

While facts and circumstances will dictate the amount of the deal proceeds that are allocable to personal goodwill, the typical fact pattern in the wealth management industry supports relatively high allocations to personal goodwill, given the deep personal relationships that advisers have with their clients.

Personal Goodwill Treatment in Divorce

Personal goodwill also has significant implications in situations involving the divorce of a partner at an RIA firm.  The treatment of personal goodwill in divorces varies from state to state, but a significant number of states allow for the exclusion of personal goodwill from the marital estate.

In professional services businesses like wealth management, the portion of the overall enterprise value attributable to the personal goodwill of partners at the firm can be significant.  The result is that the allocation to personal goodwill can significantly reduce the overall value of the divisible marital estate.  Similarly to transaction scenarios, it’s often advisable to obtain an independent valuation of the adviser’s personal goodwill in order to support the amount of the personal goodwill exclusion.

About Mercer Capital

We are a valuation firm that is organized according to industry specialization.  Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting

¹ IRS Publication 535: Business Expenses, Ch. 9, Cat. No. 15065Z