Treating Personal Goodwill as Property
The characterization of the payments from the acquirer to the selling shareholder for personal goodwill could result in one level of taxation and at more favorable capital gains rates. Buying or selling a company can be summarized into three payment types:
- Sale/purchase agreement required for the assets.
- Payments required to be allocated to the consulting agreement.
- Payments required by and allocated to the goodwill agreement.
Personal goodwill attaches to an individual, rather than a business, and differs from business goodwill. It is present when the unique expertise, reputation or relationships of an individual give a business its intrinsic value. Consider a mom-and-pop grocery store. Customers would probably find better selections and prices at the local Walmart. However, they may continue to shop at the mom-and-pop grocery store because they are loyal to the owners. If the owners retired, the business might lose its customers and much of its value. Essentially, mom and pop are the business, and the business derives its intrinsic value from them because they possess personal goodwill.
Personal goodwill is often found in professional corporations which are able to offer unique services due to the owners’ education and skills. Here, personal goodwill is called professional goodwill.
Courts have been more open to recognize personal goodwill in a professional setting because it is easier to see how a professional, (e.g., lawyer, surgeon) gives a business its return on value. This, however, does not mean that the law should afford different treatment to nonprofessionals, provided they, too, are shown to own personal goodwill. Instead, the fundamental inquiry is whether a business or its owner, professional or nonprofessional, possesses the value sought by a buyer.
Courts have held that personal goodwill, or at least professional goodwill, is property that can be bought and sold. Two well-known cases are Martin Ice Cream (MIC) and Norwalk v. Comm. (Norwalk). Both cases adopted a view that personal goodwill is property that can be transferred, and the shareholders owned personal goodwill which was intangible property. IRS TAM 200244009 provides additional guidance on the ability to sell personal goodwill by indicating that it cannot be transferred or sold separately when an employment contract and a non-compete agreement exist. In the court’s view, the fact that the shareholder of MIC never entered into a non-compete or employment agreement with MIC indicated that the shareholder had never transferred his rights to any relationships or expertise he may have had and, therefore, they remained his personal property.
In Norwalk, the court acknowledged that even when a corporation is dependent on a key employee, that employee cannot own the goodwill if the employee has entered into a covenant not to compete – or similar agreement – under which the employee’s personal relationship with clients may become the corporation’s property. Norwalk had a covenant not to compete, which ceased after seven years when the employment agreements expired. He was no longer a shareholder and, thus, no longer obligated to the corporation after it ceased to operate upon its termination and liquidation.
Unlike in Howard, 2010-2 USTC (July 2010), the court concluded that Howard was a corporate employee with a covenant not to compete, which extended for three years beyond the stock sale. When an employee works for a corporation under a contract with an agreement not to compete, the corporation – not the individual – owns the goodwill. That the goodwill may be generated from the professional’s work does not make the goodwill personal goodwill.
Personal goodwill is property belonging to the professional that can be transferred or sold separately as long as there is no employment contract or non-compete agreement between the professional and the business. Ownership of this intangible cannot be attributed to the employer, as the shareholder retains ownership of this property and can be separately bargained for when negotiating the sale of a business.
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Irving Jankovitz, CPA T (732) 572 3900 [email protected] View Experience |
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