Editor: Greg A. Fairbanks, J.D., LL.M.
Corporations & Shareholders
In general, the disposition of a corporation through an asset sale will result in two levels of tax—taxable gain to the corporation and a taxable distribution to the shareholders. A common strategy for shareholders of closely held corporations to avoid this double tax involves the assertion that a portion of the disposition of the business relates to the sale of personal goodwill of the shareholder and, therefore, a portion of the purchase price should be taxed as capital gain to the shareholder directly.
The concept of personal goodwill is well-established dating back to the decision in Martin Ice Cream Co. , 110 T.C. 189 (1998). In recent years, however, decisions in Muskat , 554 F.3d 183 (1st Cir. 2009), Howard , No. 10-35768 (9th Cir. 8/29/11), and H & M, Inc. , T.C. Memo. 2012-290, have highlighted the importance of covenants not to compete and asset purchase agreements in establishing the existence of personal goodwill.
Background
Martin Ice Cream involved a father and son who operated an ice cream distribution business through a corporation. The court determined that the success of the business depended entirely on the father, who had personal relationships with supermarket owners and an oral agreement with the founder of Häagen-Dazs to distribute a new line of super-premium ice cream to supermarkets. At no time did the father have an employment agreement with Martin Ice Cream (MIC). Following the purchase of Häagen-Dazs by Pillsbury, negotiations between MIC and Häagen-Dazs ensued for the acquisition of MIC’s ice cream distribution business. The father and son disagreed on the future of the business and decided to split the assets of the corporation in what was meant to be a tax-free split-off under Sec. 355. The court found that the transaction failed the requirements of Sec. 355 and, therefore, MIC was subject to tax on the distribution of appreciated property under Sec. 311.
In determining the tax impact to MIC, the court analyzed whether the father transferred certain intangible assets to the corporation, or if the father retained these intangible assets personally. The court held that the success of the business depended entirely on the father’s relationships in the market and his oral agreement with the founder of Häagen-Dazs, which represented valuable intangible assets. These assets could not be considered to be owned by MIC because the father never entered into a covenant not to compete or any other agreement with MIC that would result in a transfer of rights in those assets to MIC.
Purchase Agreement
In Muskat, Irwin Muskat was the CEO and a majority shareholder in a meat company. Muskat had many valuable relationships with customers, suppliers, and distributors. Under his leadership, the annual revenues of the meat company increased greatly. Muskat negotiated the sale of the assets of the meat business to a competitor and also entered into an employment agreement and noncompetition agreement with the buyer. The noncompetition agreement was to cover a 13-year period, and the payment obligation would survive Muskat’s death.
Muskat originally reported the noncompetition payments as ordinary income on his personal return but later amended it to recharacterize the payments as capital gain from the sale of personal goodwill. The court asserted that “strong proof” must be shown to recharacterize the payments. The strong proof rule is specific to tax cases and applies when parties to a transaction have executed a written instrument allocating sums of money for particular items, and one party thereafter seeks to alter the written allocation for tax purposes. To effect this alteration, the proponent must adduce strong proof that, at the time of the execution of the instrument, the contracting parties actually intended the payment to be something different (see Harvey Radio Labs., Inc., 470 F.2d 118 (1st Cir. 1972)).
Muskat contended that the survivability provision of the noncompetition agreement clearly reflected that the payments were for something other than his noncompetition. In addition, Muskat claimed that the terms of the employment agreement were so lucrative that it eliminated any realistic possibility, especially at his advanced age, that he would compete with the buyer. The court held, however, that the negotiations did not include a discussion of personal goodwill, and the buyer’s testimony confirmed that personal goodwill was not discussed. Further, since Muskat himself negotiated the sale and agreements, there was no evidence that the parties actually intended the noncompete payments to be payments for personal goodwill.
Recent Developments
In Howard, the taxpayer was a dentist who worked for his solely owned professional services corporation under an employment agreement. The taxpayer entered into an asset purchase agreement with a third party to sell the dental practice. The asset purchase agreement allocated a portion of the proceeds to personal goodwill.
The IRS argued that the goodwill belonged to the corporation as a result of the employment agreement, and the court agreed. The employment agreement provided that the dentist would practice dentistry solely as an employee of the corporation, and that the corporation retained complete control and authority over accepting or refusing any patient. The agreement further provided the taxpayer would not engage in any business that competed with the corporation. As such, it was concluded that any relationships the taxpayer developed might be described as personal, but the economic value of those relationships was conveyed to the corporation through the employment agreements. Although the taxpayer argued that the purchase agreement clearly represented the sale was for personal goodwill, the court, based on the above and citing Frank Lyon Co., 435 U.S. 561 (1978), employed the substance-over-form doctrine and disregarded the asset purchase agreement.
In H & M, the taxpayer operated an insurance company through a corporation in a rural town in North Dakota. The facts of the case stipulated that the taxpayer stood out among insurance agents in the area and that when customers purchased insurance from the corporation, they were really buying it from the taxpayer, as he had far more name recognition as an individual than the corporation did as an insurance company.
The corporation sold the insurance business in an asset sale to a local bank. The taxpayer entered into a covenant not to compete and an employment agreement with the bank. The employment agreement called for the taxpayer to receive an annual base salary, deferred compensation, and annual variable (performance) compensation.
The IRS argued that a portion of the compensation under the employment agreement should be allocated to the purchase price of the corporation’s assets to account for goodwill and the corporation’s other intangible assets. The IRS emphasized that the parties lacked documentation on the purchase price allocation and that the compensation under the employment agreement was excessive.
The court ruled that the IRS did not provide evidence that the corporation had other intangible assets that were not valued in the asset purchase. In addition, the court stated that there was no salable goodwill in the corporation because the taxpayer had a more recognizable name than did the corporation, implying that any goodwill would be personal goodwill. Although the court ruled that the compensation was not disguised purchase price, it did state that the compensation seemed excessive, but the issue of the allocation of the compensation between wages, personal goodwill, and the covenant not to compete on the taxpayer’s individual return was not an issue that the court had to decide.
Conclusion
The ruling in Muskat represents the typical set of facts. The individual claimed personal goodwill to lower his overall tax liability. Without clear documentation in the negotiations and the asset purchase agreement, however, it was relatively straightforward for the IRS and the court to disregard the personal goodwill, whether or not it existed.
The taxpayer in Howard , in contrast, attempted to claim personal goodwill through the asset purchase agreement. Unfortunately for the taxpayer, the employment agreement between the taxpayer and the corporation was similar to the covenant not to compete in Martin Ice Cream , again making a relatively straightforward case for the IRS and the court to disregard the goodwill as being a personal asset.
The analysis in H & M presents a different perspective on personal goodwill. Typically, a dispute involving personal goodwill involves a taxpayer’s attempting to claim personal goodwill, while the IRS argues the goodwill is a corporate asset and, thus, is subject to double tax. In H & M , the corporation was the taxpayer, and the IRS wanted to convert deductible compensation payments from the buyer into additional purchase price that would be taxable to the corporation. The court ruled, however, that the IRS did not provide enough evidence to establish that the corporation owned intangible assets, although the compensation payments did seem excessive. This led the court to imply that personal goodwill may exist even though personal goodwill was not discussed in the sale documents. This assertion is in contrast to Muskat in which the IRS and the court required documentation of the personal goodwill in the negotiations or asset purchase agreement.
It is clear from these decisions that taxpayers must be aware of the agreements they enter into if they want to assert that personal goodwill exists. If a taxpayer enters into an employment agreement or covenant not to compete with a corporation, it is likely that the personal goodwill will be transferred to the corporation and become a corporate asset. The taxpayer would also likely be unable to receive the goodwill back tax free from the corporation, as the cancellation of the agreement would likely result in a taxable distribution of the intangibles.
Taxpayers who do not have an employment agreement or a covenant not to compete in place with the corporation should ensure they document personal goodwill in the negotiations of a sale and in the asset purchase agreement. A third-party valuation can also be helpful in establishing the existence of the personal goodwill and support the purchase price allocation.
EditorNotes
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.
