Gains & Losses
Recent Tax Court decisions in Bross Trucking, Inc., T.C. Memo. 2014-107, and Estate of Adell, T.C. Memo. 2014-155, illustrate that with the right facts, the sale of personal goodwill, as an asset separate from corporate-owned goodwill, should withstand challenge. A previous article by one of the co-authors (see Gruidl, "Personal Goodwill: Alive and Well?," The Tax Adviser (April 2009)) addressed a pair of court decisions from 2008 and 2009 that called into question whether the sale of personal goodwill remained a viable tax planning strategy and concluded that, with the appropriate set of facts and proper planning, a business owner could successfully effectuate a sale of personal goodwill. The Tax Court decisions in Bross Trucking and Estate of Adell further support that conclusion.
Why Care About Selling Personal Goodwill as an Asset Separate From the Business?
The presence of personal goodwill can provide tax-efficient opportunities in merger-and-acquisition transactions by lowering corporate-level tax upon a sale or transfer of goodwill. Further, the gain on a sale of personal goodwill is generally considered capital gain and receives a preferential capital gains tax rate (assuming the goodwill has been held by the taxpayer for more than 12 months), as opposed to the higher ordinary income tax rate for the receipt of compensation. With current federal corporate tax rates as high as 35%, a selling shareholder's direct sale of personal goodwill can often generate significant tax benefits. In addition, the buyer in such a transaction receives an amortizable step-up in asset basis upon acquiring personal goodwill from the seller, which would not occur if all the amounts paid were considered paid for the corporation's stock.
Because it is more likely that personal goodwill exists in a closely held business and the effect of double taxation on corporate earnings is a concern for those businesses, identifying personal goodwill as a separate asset occurs most often with the sale of closely held C corporations and with closely held S corporations still within the Sec. 1374 built-in gain recognition period. In addition, owners of personal goodwill who receive stock consideration in a transaction may argue that they have transferred personal goodwill to an entity in a tax-deferred exchange under Sec. 351 as opposed to having received equity-based compensation. This is most often seen when an entrepreneur receives stock in a corporation but does not transfer any property (other than personal goodwill) to the entity. Whether such a transaction represents compensation for "sweat equity" or a tax-deferred transfer of personal goodwill is subject to the same questions as an outright sale of the goodwill.
For an individual to sell personal goodwill, the asset must (1) meet the definition of goodwill from a tax perspective and (2) be owned by an individual outside of the legal business entity. After providing an overview of the Bross Trucking and Estate of Adell decisions, this item examines three distinct hurdles to meeting these requirements in light of a long history of case law, including these most recent decisions.
Bross Trucking and Estate of Adell
The main issue in Bross Trucking was the IRS's contention that Bross Trucking Inc. distributed appreciated intangible assets (including goodwill) to its sole shareholder, Chester Bross, who then transferred those intangibles to a newly created trucking entity his sons owned. In holding for the taxpayer, the court found that Bross Trucking had no corporate goodwill at the time of the alleged distribution, that Bross's goodwill constituted all of Bross Trucking's goodwill, and that Bross did not transfer any of his goodwill to the company. In this taxpayer-favorable case, the Tax Court relied heavily on the precedent in Martin Ice Cream Co., 110 T.C. 189 (1998), and distinguished the case from Solomon, T.C. Memo. 2008-102.
At issue in Estate of Adell was the value of a closely held corporation, STN.Com, at the date of the death of the owner, Franklin Adell. Both the IRS and the estate used the income approach in valuing the corporation, but the estate placed a significantly higher value on the personal goodwill owned by the decedent's son, Kevin Adell, than the value the IRS used, thereby yielding a much lower corporate value. In holding that the estate's value was correct, the court found Kevin Adell, STN.Com's president, did not transfer his goodwill to the company through a covenant not to compete or other agreement, but instead was free to leave his employment and use his personal goodwill as a direct competitor. Further, the court found that the company could not cultivate the personal goodwill of Kevin Adell on its own. Based on these factors, the court determined the IRS's value for Kevin Adell's goodwill was not high enough.
Hurdle No. 1: Personal Goodwill Exists That Is Separate From Corporate Goodwill
The first and seemingly most obvious requirement is to establish that personal goodwill exists separate from corporate goodwill. Personal goodwill is property with a value dependent solely on the personal characteristics of its business owner (see MacDonald, 3 T.C. 720 (1944)). Although very fact-specific, these personal characteristics can include the personal relationships, ability, personality, and reputation of a shareholder-employee where a business does not have a right by contract or otherwise to that individual's future services (see Martin Ice Cream Co.,110 T.C. 189 (1998); Norwalk,T.C. Memo. 1998-279; and Schilbach, T.C. Memo. 1991-556).
In Bross Trucking, Bross, a successful construction businessman, had established close, personal relationships with his primary customers. Additionally, Bross was extremely knowledgeable about the trucking industry because of his many years of experience. To that end, customers sought these personal traits through their relationships with him, which led directly to business for Bross Trucking. As a result, the Tax Court determined personal goodwill existed through these relationships.
The Tax Court found the facts in Bross Trucking analogous to those in Martin Ice Cream. In Martin Ice Cream, the corporation's success was attributed to a shareholder's relationships with his customers, which constituted an asset used to establish revenue streams and develop a customer base. However, because these relationships and the corresponding intangibles were never transferred to the corporation, the intangibles were held to be the shareholder's. Similarly, the court in Bross Trucking held that any existing goodwill from Bross's relationships was personal goodwill.
A significant factor in Bross Trucking supporting the position that it was personal goodwill was that the corporation clearly lacked its own goodwill. The corporation had an impending suspension from various regulatory infractions, causing it to face bankruptcy. Further, the impending suspension caused customer uncertainty and business interruptions that impaired business. The negative image of Bross Trucking was so strong that Bross's three sons started a new trucking business using many of the same vehicles but eliminating the Bross Trucking logo from the vehicles. The Tax Court identified this as the "antithesis of goodwill" and concluded that while the business may have had corporate goodwill at some point, any remaining goodwill was not the corporation's, but instead stemmed from Bross's relationships with his customers. Unlike many situations involving claims of personal goodwill, the nonexistence of corporate goodwill in this case was clear.
Further, the Tax Court distinguished Bross Trucking from Solomon, where corporate success occurred because of the products and not because of the relationships the shareholders formed. In Solomon, the taxpayers failed to convince the court that their personal abilities in developing an iron ore processing business were of any value. The court said that the acquiring party "did not need the goodwill of Solomon Colors or any of its key employees to succeed; in fact, after the acquisition [the acquiring party] continued to do business under its own name, not under the name of Solomon Colors." Additionally, in Solomon, the selling shareholders effectively ended their involvement in the business following the sale, further indicating their personal abilities were dispensable.
Turning to Estate of Adell, Kevin Adell helped his father build a television station, culminating in the incorporation of STN.Com. Franklin Adell owned 100% of STN.Com, and Kevin Adell was on the board of directors and ran various day-to-day operations. Franklin Adell and Kevin Adell then sought to create The Word, a religious television station. To do so, Kevin Adell met with religious leaders all over the country to gain support. Ultimately, The Word was incorporated as a nonprofit organization that engaged STN.Com to provide uplink and other services. The Word's primary source of revenue was from broadcasting contracts that Kevin Adell, as a representative for The Word, negotiated with the various religious leaders. In turn, the service fees The Word paid to STN.Com represented nearly all of STN.Com's revenue.
Franklin Adell and Kevin Adell ran The Word, with Franklin Adell acting as president and director and Kevin Adell as treasurer, secretary, and director. In this case, Franklin Adell's estate identified personal goodwill owned by Kevin Adell and reduced the projected operating cash flow of STN.Com for the economic charge it assumed would be required to acquire Kevin Adell's personal goodwill. But the IRS determined that a hypothetical willing investor would be able to retain Kevin Adell for an acceptable salary significantly lower than the economic charge used by the estate. The Tax Court, however, agreed with the value the estate placed on Kevin Adell's personal goodwill.
To benefit from the personal goodwill tax strategy, the first hurdle is proving goodwill exists independent of any corporate goodwill. This generally requires a shareholder to possess one or more personal characteristics essential to the success of the business (see Estate of Taracido, 72 T.C. 1014 (1979)). Further, the courts are likely to examine the corporation's existing goodwill to distinguish it from any personal goodwill. To that end, the facts in Bross Trucking were extremely taxpayer-favorable given the company's complete lack of goodwill.
Hurdle No. 2: Personal Goodwill Must Be Separate From the Business's Assets
A second noteworthy requirement is that the individual possesses the right to sell the goodwill. To avoid corporate-level tax, the personal goodwill must be the shareholder's asset, and the shareholder cannot have previously transferred the asset to the corporation. Tax Court precedent establishes that personal goodwill is transferred to the corporation when the individual cannot personally benefit from it without the employer (see, e.g., Martin Ice Cream Co., 110 T.C. 189 (1998); Norwalk, 76 T.C. Memo. 1998-279; H & M, Inc., T.C. Memo. 2012-290; and Bross Trucking, Inc., T.C. Memo. 2014-107).Personal goodwill is often transferred through agreements such as employment contracts or noncompete agreements. In general, once such an agreement is in place, any existing goodwill (or goodwill generated after) likely belongs to the corporation.
In Bross Trucking, Bross never entered into an employment contract or a noncompete agreement. He was free to leave the company and take his relationships with him if he chose to compete against the business. The court stated that "[a]n employer has not received personal goodwill from an employee where an employer does not have a right, by contract or otherwise, to the future services of the employee." As a result, the lack of those agreements allowed the Tax Court to conclude Bross did not transfer any goodwill to the corporate entity. Similarly, in Estate of Adell,the Tax Court noted that Kevin Adell never transferred his goodwill to STN.Com through a covenant not to compete or any other agreement. Instead, the court said, "Kevin [Adell] was free to leave STN.Com and use his relationships to directly compete against his previous employer."
The favorable facts in Bross Trucking and Estate of Adell can be contrasted with those in Howard, No. 10-35768 (9th Cir. 8/29/11). There, Larry Howard, a practicing dentist, incorporated his sole proprietorship and entered into an employment contract and a noncompetition agreement with the business. Later, Howard sought to sell his practice, which he argued included the sale of personal goodwill. The IRS, however, recharacterized the payment Howard received and claimed to be for the sale of personal goodwill, as a dividend payment from the corporation. The court held that personal goodwill did not exist separate from the corporate assets. Specifically, the court noted that, although Howard possessed some personal goodwill through his patient relationships, "the economic value of those relationships did not belong to him, because he had conveyed control of them to [his business]." As a result, the court upheld the IRS's recharacterization of the payment as a dividend.
Hurdle No. 3: Observing Formalities and Preparing Documentation to Further Bolster Characterization
While not an issue in Bross Trucking or Estate of Adell, it is worth noting that certain formalities and documentation will help support positions taken for personal goodwill. Personal goodwill should be valued by a third-party appraiser, be clearly identifiable in purchase price agreements, and be agreed to by the acquiring party.
In Kennedy, T.C. Memo. 2010-206, James Kennedy, the sole shareholder of KCG International, sold his consulting corporation. Late in the negotiation process, the parties agreed that 25% of the purchase price should be designated as payment for consulting services and that the remaining 75% should be designated as payment for Kennedy's goodwill. To effectuate the sale of the personal goodwill, the parties entered into three separate agreements, one of which was for the sale of Kennedy's goodwill and customer lists. In a separate agreement, Kennedy agreed to continue to service his former clients as an employee of the acquirer.
While the Tax Court did find that Kennedy owned personal goodwill, it held that the identification of personal goodwill is not enough to conclude that the goodwill was sold. The Tax Court stated that "[e]ven though a payment to a service provider can be considered a payment for goodwill in certain circumstances, we are convinced that the payments to Kennedy were consideration for services rather than goodwill." The Tax Court went on to state that it found
it significant that there is a lack of economic reality to the contractual allocation of the payments to goodwill. In other cases, the contractual allocation of a portion of a payment to goodwill has been important in determining that the payment was indeed for goodwill. In those other cases, the contractual allocation appeared to genuinely reflect the relative value of the seller's customer relationships compared to the value of the seller's ongoing personal services. [Kennedy, T.C. Memo. 2010-206 at *23]
The Tax Court's finding turned on the lack of a third-party appraisal or any other meaningful attempt to allocate the sales proceeds. Thus, Kennedy illustrates the importance of formally documenting the value of personal goodwill with third-party appraisals to support contractual price allocations.
In addition to supporting value, documentation helps support the intention of the parties. In Muskat, 554 F.3d 183 (1st Cir. 2011), a shareholder attempted to recharacterize ordinary income from the sale of a meat-processing business as a capital gain from the sale of personal goodwill. However, the purchase agreement never mentioned the existence of the taxpayer's personal goodwill and instead 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 agreement.
The Tax Court also looked to the language of the purchase agreements in Solomon. In Solomon,the taxpayers (father and son shareholders) argued the acquiring party purchased the shareholders' personal assets that represented value generated from their customer relationships. In its holding, the Tax Court noted three reasons the taxpayers did not sell personal goodwill. First, nothing in the agreement between the parties referred to the sale of personal goodwill or customer lists personally owned by the taxpayers. Second, unlike in 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. As a result, the payments were attributable to the taxpayers' covenants not to compete.
Based on the foregoing, it is clear that a lack of supporting contractual documentation and an appraisal impedes an otherwise strong case for the sale of personal goodwill.
Bross Trucking and Estate of Adell exemplify the idea that facts and circumstances will carry the day for personal goodwill. Since Martin Ice Cream, additional cases have also shown that the facts and circumstances will determine whether goodwill is the shareholder's or the company's. These precedents have provided a road map to overcome hurdles faced when demonstrating the existence of personal goodwill. The road map includes documenting the traits and characteristics of personal goodwill used in the operation of the business, documenting evidence supporting the ownership of that goodwill outside of the corporation (i.e., a lack of employment contract or noncompete agreement before any sale or transfer of goodwill), and entering into formal agreements that support the desire for and continuation of the goodwill following the transfer. Taxpayers wishing to assert personal goodwill need to ensure they have properly documented their positions and have the appropriate defenses ready in case of an IRS challenge.
Mindy Tyson Weber is a senior director, Washington National Tax for McGladrey LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with McGladrey LLP.