Personal Goodwill and the C Corporation Business Sale
May 1, 2024 - Publication
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Purchasers of a C corporation business generally prefer to buy assets to obtain depreciation and amortization deductions, while sellers of a C corporation business generally prefer to sell stock and recognize only one level of tax at long-term capital gain rates or even exclude gain if the stock qualifies under §1202.
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Unfortunately, C corporation asset sales trigger taxable gain and a subsequent liquidation of the C corporation results in a second level of tax. Many sellers and their legal counsel are unfamiliar with the ability to separately sell personal goodwill owned by the shareholders to avoid corporate level gain recognition on a portion of the asset sale transaction, in situations where the facts support the existence of personal goodwill.
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Start Planning Sooner than Later. How about Now?
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Discussions between the seller and purchaser about personal goodwill should occur as early as possible in the sales process, with personal goodwill specifically mentioned in the letter of intent and documented in other communications between the seller and the purchaser.
“Last minute” allocations or inappropriately documented allocations of personal goodwill have been denied by the courts. ((See, e.g., Muskat v. U.S., 2008-1 USTC ¶50,283 (DC N.H. 2008), aff’d, 554 F.3rd 183 (1st Cir. 2009); Solomon v. Comm., 95 TCM 1389 (2008); Kennedy v. Comm., 100 TCM 268 (2010).) Informed sellers and their attorneys and/or CPAs will educate the purchaser and the purchaser’s attorney about the existence of personal goodwill and that structuring the transaction to separately provide for the sale of the shareholders’ personal goodwill does not: (i) economically disadvantage the purchaser (paying the same price), (ii) change the amount or timing of future tax deductions to the purchaser, (iii) omit any assets from the operation of the business going forward, or (iv) represent risk to the purchaser, if the transaction is handled properly.
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Reg. §1.197-2(b)(1) defines goodwill as “the value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor.” The seminal case supporting the recognition of a goodwill as personal to a shareholder (commonly referred to as personal goodwill) is Martin Ice Cream v. Comm., 110 TC 189 (1998). (See also Norwalk v. Comm., 76 TCM 208 (1998) in which personal goodwill of shareholders in a CPA practice was recognized where no non-solicitation agreements existed between the shareholders and the CPA practice; Bross Trucking v. Comm., TC Memo 2014-104.)
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What is the Benefit of Personal Goodwill to the Seller?
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Any amount of purchase price allocated to personal goodwill is not taxed to the C corporation and again to the shareholder as a dividend or liquidating distribution (including the additional 3.8% NIIT of §1411). (A liquidating distribution can qualify for the §1202 exclusion; however, the tax on the asset sale does not.) Rather, the amount allocated to personal goodwill bypasses C corporation taxation (because it is not an asset of the C corporation) and is taxed by the individual shareholder who receives the payment as long-term capital gain that is not subject to the additional 3.8% NIIT of §1411 because it was an asset used in the shareholder’s trade or business. (See §1411(c)(1)(A)(iii))
- What is Required?
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Determine the amount of personal goodwill (a personal goodwill appraisal is recommended). The shareholders receiving a purchase price allocation of personal goodwill cannot have a non-solicitation and/or a non-compete agreement in place with the C corporation. Upon the sale of personal goodwill, the selling shareholder should enter into a non-solicitation and/or non-compete agreement with the purchaser and agree to transition the personal goodwill to the purchaser (for which the shareholder will be compensated). Otherwise, the reality of the personal goodwill value becomes questionable because it was not worthy of being protected for the purchaser.
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For example, A and B each own half the stock of AB Inc., a business in which they are material participants (as defined in §469). AB Inc. is taxed as a C corporation. The stock owned by A and B is not eligible for the §1202 exclusion. Neither A nor B has entered into a non-compete or non-solicitation with AB Inc. A purchaser has offered $4,000,000 for the assets of the business. An appraiser determined that $1,900,000 of the purchase price is attributable to the personal goodwill of the shareholders and the purchaser agrees to pay the shareholders directly for their personal goodwill. The result is $1,900,000 bypassing the 21% corporate tax and the subsequent 23.8% individual tax rate upon distribution of the remaining proceeds as a dividend or liquidating distribution. Instead, the $1,900,000 allocated to personal goodwill of the shareholders is taxed only once at the 20% individual long-term capital gain tax rate.
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Immediate Next Steps
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If you think your business sale might include personal goodwill or are unsure how personal goodwill affects your sale price and the tax implications, contact your legal counsel or tax advisor immediately. For those of you who are unsure when (or even if) to sell your business, add “personal goodwill” to the next conversation with your advisors, whether it’s your legal counsel, accountant or board.
