September 1, 2011
A recent Ninth Circuit case (Larry E. Howard v. U.S., (CA 9 8/29/2011) 108 AFTR 2d ¶ 2011-5226)confirms that if there is a non-compete agreement between the company and the owner, then the IRS will argue there is no personal goodwill. Having an employment agreement between the employee/owner and company also hurts the personal goodwill argument but still allows an argument without the non-compete.
If there is no employment agreement and no non-compete, then the personal goodwill argument definitely has merit. The benefit of selling personal goodwill is that the income is taxed only once to the owner and is long-term capital gain taxed very favorably under current law. If the corporation is a C corporation, then double taxation occurs if corporate goodwill is sold versus personal goodwill.
It is a slippery slope on whether to have employment agreements and non-competes since this does protect the company from the employee leaving and then competing. However, in this case below, since it was a one owner employee dentist, it seems he really did not need the employment agreement or non-compete, thus was hurt tax-wise on the sale.
Very good article. How does a consulting agreement between the company and an owner affect a the personal goodwill argument?
Thanks for your question, John. I think any agreement between the company and the owner hurts the personal goodwill argument. Using a consulting agreement as a way to show the value is with the consultant who is outside of the entity and not an employee seems to make sense but would be challenged in my opinion by the IRS that the owner controlled the company and in substance this is like an employment agreement. I am not an attorney, so it would be worth talking with an attorney if there is a legal position to rebuke IRS argument on substance over form.
Interesting. Assuming there isn’t a non-compete or employment agreement between an owner and the C corp being sold, and the owner has significant relationships with all of the corporations customers, what % of a transaction could reasonably be attributed to personal goodwill before it would likely attract the attention of the IRS (in a situation where the tangible assets of the company are relatively small - say 25% of purchase price)?
To your question, Mark, it is all facts and circumstances. Without noncompete and employment agreement, I believe an argument could be made that most of selling price is for personal Goodwill.
I have a C corp owned 50% by mon, 30% by dad and 10% each be 3 children. None of the children is interested in owning the business, so the business is up for sale. Mom is the driving force for the success of the business. An offer has been received for the business as a asset purchase. The fmv of the hard assets is approximately 350,000 out of a total sales price of 1,100,000, so clearly a case for personal good will. The problem is mom died last July and dad inherited her 50% ownership. Any thoughtd if mom’s goodwill survives her death?
It is a facts and circumstances situation. Did mom’s estate have to file a state inheritance or federal gift tax return? Was any personal Goodwill value shown on these returns? I have not seen this. Probably a stretch. A great answer if it does with step up in value of personal Goodwill if not a taxable estate. Sell at no gain after death. Very aggressive.