In the sale of a C corporation, goodwill in many cases is the property of a shareholder rather than of the corporation. The Tax Court has found this to be the case where the success of the corporation depended on the shareholder's ability and reputation and there was no noncompete agreement between the shareholder and the corporation. The shareholder must recognize the income from the sale of the goodwill as capital gain.
However, a related question arises: Is that gain subject to the net investment income tax under Sec. 1411? Many commentators seem to assume that it is. However, a careful analysis of the net investment income tax and passive activity loss regulations should lead to the opposite conclusion for most sales of personal goodwill. This article looks at the circumstances under which goodwill can be considered a shareholder's property and why the income from the sale of goodwill developed by the personal efforts of the individual should not be subject to the net investment income tax.Sales of Goodwill
Double-taxation arises upon the sale or distribution of C corporation assets in a C corporation liquidation or upon the sale or distribution of an S corporation's assets subject to the built-in gains (BIG) tax in an S corporation liquidation. The corporation pays tax on the sale or distribution of the assets. The shareholders pay tax again on the amount of their liquidation distribution less their stock basis.
However, if intangible assets associated with a sale are properly characterized as the property of the shareholders, the double-taxation is reduced. For example, upon a sale of a business, a portion of the consideration might be for the selling shareholder's covenant not to compete or to contractually bind the individual to perform consultation services to the purchaser of the business. These types of arrangements will result in ordinary income (not capital gain) to the selling shareholder rather than income to the corporation.
A number of court cases have addressed the issue of whether, in the sale of a corporation, goodwill was the property of the selling corporation or of the selling shareholder. In Martin Ice Cream Co.,1 the Tax Court reviewed the value of assets split off from a corporation in preparation for a sale. The court divided the intangible assets into two groups. One group, including assets such as business records of the business, was the property of the corporation. The other group, the intangibles assets, consisting of an oral contract made by one of the corporation's two shareholders with the corporation's primary supplier and that same shareholder's relationships with customers of the business, was found to be assets of that shareholder. A factor in the decision was the lack of any noncompete agreement between the shareholder and the corporation. The issue was how to determine the value of a split-off corporation that did not qualify for nonrecognition of corporate gain under Sec. 355. The IRS asserted that the value of the corporation split-off included goodwill. The court found that the goodwill belonged to the shareholder and should not be included as an asset of the corporation in determining the corporation's value.2
In Norwalk,3 the Tax Court similarly found that no corporate goodwill existed because the professional accounting practice of the corporation depended upon the key employees of the corporation. There were no noncompete agreements between the corporation and the shareholders, and the court found that the personal ability and reputation of the shareholders were the assets of the shareholders and not assets of the corporation passing to the shareholders in the liquidation of the corporation, labeling these assets as personal goodwill.
Although the payment for personal goodwill is either made (or treated as being made) to the individual owner or owners of a corporation, its status as an asset of the owner or owners is obscured because its sale is directly associated with the sale of the corporation or its assets. Evidence that goodwill is a personal rather than a corporate asset is supported if the shareholders negotiate the sale of goodwill separately from the negotiation by the corporation of the sale of its assets.4 Additional support is found if the shareholders' personal goodwill is not divided pro rata among the shareholders in the same percentage as the ownership of the stock, but rather each shareholder receives separate consideration for the sale of his or her own personal goodwill.
The sale of personal goodwill generates gain. A sale of personal goodwill may accompany the sale of a business through a sale of a corporation's stock or the sale of a corporation's assets. A shareholder of an S corporation may also benefit from the sale of personal goodwill if that S corporation selling assets is otherwise subject to the BIG tax under Sec. 1374. Personal goodwill, which is held by the shareholder, is not subject to the BIG tax because it is not a corporate asset held at the effective date of the S election.Net Investment Income Tax
Although it has been established that the sale of a shareholder's personal goodwill may generate capital gain to the shareholder, a related question is whether that capital gain is net investment income for purposes of the net investment income tax. Sec. 1411 was enacted in 2010,5 and it imposes a 3.8% tax on net investment income (over certain thresholds) of individuals, estates, and trusts, effective for tax years beginning in 2013. Net investment income includes net gains from the disposition of property except to the extent attributable to a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities.6 Consequently, the default is that all capital gain is net investment income unless an exception applies.
Sec. 1411 includes an exception for the disposition of active interests in partnerships and S corporations.7 However, to the extent that the net gain from such a disposition would have been subject to net investment income tax had the entity sold its property immediately before the disposition of the ownership interest, the disposition gain is subject to net investment income tax.8 The exception applies only to partnership and S corporation interests, however. No exception is available for dispositions of stock in a C corporation.
The activity of a C corporation is not a trade or business with respect to the individual shareholder. Regardless of the level of participation of the shareholder in the C corporation's business, the gain on the sale of C corporation stock is net investment income. Unless the corporation can elect S status prior to the shareholder's sale of stock, the gain on the sale of stock is subject to net investment income tax. Likewise, the liquidation gain to the shareholder of a C corporation is subject to net investment income tax.
If personal goodwill is sold in conjunction with the sale of a business in the corporate form, at first glance, it would seem appropriate to treat the gain from its sale as gain from the sale of an investment asset and include it in net investment income. However, a closer look reveals that the gain should be excluded, based on how the passive activity rules apply to income from personally created intangibles and to income from personal service activities.Analysis
With respect to the net investment income tax, the important characteristic of personal goodwill is that it is a personally developed intangible asset for purposes of the passive loss rules. Under those rules, the gross income of an individual from intangible property, "such as a patent, copyright, or literary, musical, or artistic composition, if the taxpayer's personal efforts significantly contributed to the creation of such property" is excluded from the definition of passive activity gross income.9 Personal goodwill does not on its face seem like a patent, copyright, etc., but it is an intangible that was personally developed by the seller. The provision excluding from passive activity income any gross income that is derived by a creator of an intangible is under the temporary regulations' heading of "Other items specifically excluded."10 Therefore, gain from the sale of personal goodwill is not passive activity income and, consequently, it should be excluded from net investment income under Sec. 1411(c)(1)(A)(iii), so it is not subject to the net investment income tax.
Furthermore, personal goodwill is created by personal service activities, and, therefore, income from the disposition of goodwill should not be treated as passive. The starting point in determining whether gains are subject to the net investment income tax is Sec. 1411(c)(1)(A)(iii), which taxes all net gains from the disposition of property other than property held in a trade or business (other than the trade or business of trading in financial instruments or commodities) that is not passive. To be excluded, therefore, the gain has to be from a trade or business, and the taxpayer has to be "not passive" with respect to that trade or business. Taxpayers are directed11 to Sec. 469 for the meaning of the term "passive activity": any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate.12
Earned income is not taken into account in computing the income or loss from a passive activity.13 Earned income for this purpose includes wages, salaries, professional fees, and other amounts received as compensation for personal services actually rendered.14 A personal service activity is one that involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting or any other trade or business in which capital is not a material income-producing factor.15 These concepts are repeated within the regulations.16
Another provision in the regulations treats income from personal service activities as material participation income. Individuals are deemed to materially participate in an activity if it is a personal service activity and they actually materially participated in the activity for any three tax years preceding the current tax year.17
Income from a business in which capital is not a material income-producing factor is not currently defined. However, the pre-1982 Internal Revenue Code included Sec. 1348, which limited the tax rate applicable to earned income. "Earned income" was not defined in Sec. 1348, but the section referred to Sec. 911(b). The provision in Sec. 911(b) was moved and reworded into Sec. 911(d) in 1981.18
Keep in mind the environment under which the passive activity rules were promulgated in the Tax Reform Act of 1986.19 They were designed to prevent taxpayers from artificially creating passive income. Most, if not all, income associated with more than an incidental level of personal services is classified or recharacterized as not passive, while deductions and losses associated with taxpayers' passive activities are limited. The IRS was empowered to issue regulations to prevent taxpayers from structuring income-producing activities to produce passive income that could offset passive losses.20 These recharacterization provisions, included in regulations under Sec. 469 to prevent the creation of passive income, work to reduce the taxpayer's exposure to net investment income tax.
Taken together, the provisions excluding personal service income and income from intangible property from passive income indicate that property developed by the personal efforts of the individual does not generate passive income for the individual. It should not matter that such goodwill, associated with the individual, enhanced the value of the business being conducted by a C corporation.
1Martin Ice Cream Co.,110 T.C. 189 (1998).
2Note that the shareholder's taxation was not before the Tax Court, however. The court did not have occasion to discuss the character of the income as payments for services or payments for a capital asset. See Kennedy, T.C. Memo. 2010-206.
3Norwalk, T.C. Memo. 1998-279.
4Kennedy, T.C. Memo. 2010-206. The court stated that allocation to goodwill of 75% of the total consideration paid was a tax-motivated afterthought that occurred late in the negotiations.
5Patient Protection and Affordable Care Act, P.L. 111-148, as amended by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
9Temp. Regs. Sec. 1.469-2T(c)(7)(i).
15Temp. Regs. Sec. 1.469-5T(d).
16See Temp. Regs. Sec. 1.469-2T(c)(4).
17Temp. Regs. Sec. 1.469-5T(a)(6).
18Economic Recovery Tax Act of 1981, P.L. 97-34, §111.
19Tax Reform Act of 1986, P.L. 99-514.
20S. Rep't No. 99-313, 99th Cong., 2d Sess., at 731 (1986).
|Christopher Hesse is a principal in the National Tax Office of CliftonLarsonAllen LLP in Minneapolis. He is also a member of the AICPA Tax Executive Committee and a former chair of the AICPA S Corporation Technical Resource Panel. For more information about this article, contact email@example.com.