A pair of recent decisions calls into question whether the sale of personal goodwill is still available as a tax planning strategy. In both Solomon, T.C. Memo. 2008-102, and Muskat, No. 08-1513 (1st Cir. 1/29/09), the courts held that the purported sales of personal goodwill were in fact compensatory payments under covenants not to compete.
So is personal goodwill dead? No. A closer look at each case shows that with the correct set of facts and the proper planning, personal goodwill remains a viable tax planning idea for owner-managed businesses. However, these cases give taxpayers and advisers fair warning that the IRS is willing and able to attack bad fact patterns, shortcuts, and last-minute tax advice.
Background
The sale of personal goodwill held directly by the selling shareholder avoids corporate-level tax and results in longterm capital gain (assuming the goodwill has been held by the taxpayer for more than 12 months). With current corporate and top individual tax rates of 35%, the benefits of the sale of personal goodwill are often quite significant to the seller. Similarly valuable to the buyer is the amortizable step-up in asset basis obtained upon the acquisition of personal goodwill from the seller that would not be available if the entire consideration were paid for the stock of the corporation.
As a result of double taxation of corporate earnings, the identification of personal goodwill as a separate asset occurs most often within the context of the sale of closely held corporations (either closely held C corporations or S corporations within the 10-year Sec. 1374 built-in gain period).
True to its name, the asset personal goodwill must meet the definition of goodwill from a tax perspective, and it must be owned by an individual. Goodwill is defined in legislative history, regulations, and numerous court decisions. The consensus is that goodwill represents the intangible qualities that bring with them continued patronage. (See H.R. Rep’t 103-111, 103d Cong., 1st Sess., House Committee Report to the Omnibus Budget Reconciliation Act of 1993, P.L. 103-66; Regs. Secs. 1.197-2(b)(1) and (2); Houston Chronicle Pub. Co., 481 F.2d 1240 (5th Cir. 1973), cert. denied, 414 U.S. 1129; Winn-Dixie Montgomery, Inc., 444 F.2d 677 (5th Cir. 1971); Killian, 314 F.2d 852 (5th Cir. 1963); Nelson Weaver Realty Co., 307 F.2d 897 (5th Cir. 1962); Karan, 319 F.2d 303 (7th Cir. 1963).)
Tax Court precedent establishes that when an individual does not have an employment contract, the individual’s personal relationships and other assets constituting goodwill are assets distinct from corporate goodwill. (See, e.g., Norwalk, T.C. Memo. 1998-279; Martin Ice Cream Co., 110 T.C. 189 (1998); Schilbach, T.C. Memo. 1991-556; Estate of Taracido, 72 T.C. 1014 (1979); Cullen, 14 T.C. 368 (1950); MacDonald, 3 T.C. 720 (1944); Providence Mill Supply Co., 2 B.T.A. 791 (1925).) The two cases cited most frequently by tax practitioners are Norwalk and Martin Ice Cream.
One of the earliest cases dealing with personal goodwill clearly distinguished personal goodwill from corporate intangibles, stating that “‘good will does not adhere to a business or profession dependent solely on the personal ability, skill, integrity or other personal characteristics of the owner.’ [Citation omitted.] It is different from, and is not to be ‘confused with, “going value” or “going concern value” of a business’” (MacDonald, 3 T.C. 720, 727 (1944) (quoting 38 Corpus Juris Secundum 949 and 952 (1943))).
Recent Decisions
As mentioned earlier, the Solomon and Muskat decisions each held against the taxpayers’ contentions that they had sold personal goodwill, holding instead that the payments received represented compensation taxed at ordinary income rates. It is interesting to note that the Service argued in each case that the payments were compensatory in nature rather than disguised payments for the corporate assets. As a result, neither decision resulted in double taxation of the proceeds paid to the shareholders. This may have been the result of the facts in each case; however, it is worth consideration when determining the risk associated with taking a personal goodwill position.
Solomon: The Solomon decision is a good example of bad facts leading to a taxpayer loss. The taxpayers attempted to claim that the proceeds they received related to the sale of customer lists, which they argued were their personal assets. The business in Solomon was iron ore processing, a far cry from the relationship-driven businesses in Martin Ice Cream and other favorable decisions. In fact, the court cited a communication from the taxpayers’ accountant stating that the goodwill arguably was more related to the entity than the shareholders.
In ruling against the taxpayers, the court cited three primary reasons. First, nothing in the agreement between the parties made reference to the sale of personal goodwill or the customer lists by the taxpayers. Second, unlike Martin Ice Cream, the facts did not support that the value of the business was attributable to the taxpayers’ personal attributes and relationships. Third, though the taxpayers entered into noncompete agreements, the lack of employment or consulting agreements arguably showed that the intent was not the purchase of personal goodwill.
Muskat: While Solomon was a case of bad facts, Muskat took poor decision making to a new level. The taxpayer in Muskat originally filed his return reporting compensation upon entering into a covenant not to compete upon the sale of his business. The taxpayer subsequently filed an amended return claiming that the payment was in fact for his personal goodwill.
While the facts related to the business operations in Muskat appeared more in line with Martin Ice Cream and other cases holding for the existence of personal goodwill, nothing in the agreement between the parties supported the taxpayer’s claim. The existence of the taxpayer’s personal goodwill or sale of such goodwill was never discussed, and the purchase agreement allocated all goodwill to the company. Following its application of the “strong proof” rule, the court held that the taxpayer’s assertions were not enough to overcome the intent as expressed in the form of the agreement (Muskat, No. 00-cv-30-JD (D.N.H. 4/2/08)). One could argue that the court applied a form-oversubstance argument.
In affirming the lower court’s decision, the First Circuit looked at ownership of the goodwill as well. The court agreed with the lower court’s exclusion of expert testimony, stating:
If [the CPA expert witness] planned to testify that Muskat possessed personal goodwill separate from [the company’s] goodwill, his testimony arguably may have been relevant to that issue. But according to the proffer, [the CPA] would not have testified to that effect; rather, he would have testified that a large slice of [the company’s] goodwill was attributable to Muskat. This is a significant distraction. All of [the company’s] goodwill, including any portion attributable to Muskat, was sold under the asset purchase agreement. Thus, [the CPA]’s testimony would have shed no light on the meaning of the noncompetition agreement. [Muskat, No. 08-1513 (1st Cir. 1/29/09)]
On a more disturbing and potentially far-reaching note, the lower court made the statement that it is not clear that saleable personal goodwill exists in situations like those in Muskat. However, such a statement should not be looked at as a repudiation of the long line of Tax Court decisions that embrace the existence of personal goodwill.
Conclusion
With the right facts, personal goodwill appears to remain a viable strategy. However, to withstand scrutiny by the Service, it is important that taxpayers and advisers alike clearly establish and document both the existence of personal goodwill and the value of such goodwill. The rewards are large (avoiding corporate-level tax while obtaining long-term capital gain), but as these recent cases show, the risks are many.
EditorNotes
Mindy Cozewith is director, National Tax, at RSM McGladrey, Inc., in New York City.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Ms. Cozewith at (908) 233-2577 or mindy.cozewith@rsmi.com.
