In 1998, two cases involving the concept of "personal goodwill" opened the door to a strategy for avoiding the double taxation to which C corporations and their shareholders can be subject when assets of the C corporation's business are sold. For nearly a decade the courts had nothing more to say about this form of planning, but tax advisors continued to use it - sometimes in appropriate circumstances and sometimes not. Between 2008 and 2011, several of the "sometimes not" cases were decided. While the taxpayers in these cases all lost, it was their execution of the strategy that failed, not the strategy itself. In fact, these cases taken together can provide a roadmap for how and when the strategy can be used successfully.
The Problem - Double Taxation
While many newly formed, closely-held businesses today select the LLC as their choice of entity, there are still numerous closely-held businesses operated in corporate form. And among those, there are still many that for a variety of reasons continue as C corporations. Those reasons can include not wanting to deal with the built-in gains tax or the LIFO recapture tax that can apply when a C corporation converts to S corporation status and a desire to take advantage of the graduated corporate income tax rates and certain non-taxable perquisites that are available in C corporation form.
The most significant potential downside to operating as a C corporation arises, however, when the business is sold. Because there is no corporate-level capital gain rate, the effective federal income tax rate on a sale of C corporation assets followed by a liquidation of the corporation is approximately 45% (combining the 35% corporate level tax on the full proceeds from the sale of the assets and the 15% capital gain rate on the distribution of the after-tax proceeds of the sale). In contrast, the federal income tax rate in the case of an asset sale by a flow-through entity (an S corporation without built-in gain issues, a partnership or an LLC taxed as a partnership) is 15% in the case of assets qualifying for long-term capital gain treatment. The 30% rate differential generally is higher when state income taxes are taken into account. Of course, the seller may attempt to avoid the double tax by engaging in a stock sale. However, most sophisticated buyers who agree to a stock sale will discount the purchase price because of the lack of an inside basis step-up in assets, often effectively resulting in the seller netting something close to what would be received in the case of an asset sale.
A Potential Solution - the "Personal Goodwill" Strategy
In appropriate situations, a now-common planning approach to the double-taxation problem is for the shareholders to sell their "personal goodwill" in the business. If successful, the sellers pay a single level of tax at long-term capital gain rates and the buyer obtains the same amortizable asset it would have received had it purchased an intangible asset from the corporation. The two cases that approved this approach in 1998 were Martin Ice Cream Co. v. Commissioner, 110 TC 189 (1998), and Norwalk v. Commissione, 76 TCM 208 (1998).
In Martin Ice Cream, a father and son had a dispute as to the direction that an ice cream distribution business that was operated in corporate solution should take. To settle the dispute, the corporation (the taxpayer in the matter) engaged in a purported spin-off transaction, a distribution of one of the lines of business of the corporation to the father, which the Tax Court found not to be tax-free. The taxpayer, however, was able to sustain its position that the portion of the consideration received by the father that was attributable to the father's distributor relationships was not attributed to a distribution from the corporate taxpayer. Rather, the Tax Court held that the relationships belonged to the father, individually, thereby characterizing such consideration as a direct payment for the purchase of a capital asset from the father, instead of being a distribution of an appreciated corporate asset in a failed spin-off transaction.
Similarly, in Norwalk, an accounting practice that was operated in corporate solution was liquidated, and the two shareholders entered into a partnership with several other accountants. The IRS asserted that the corporation had goodwill and going concern value and, therefore, the liquidation resulted in double tax on the deemed distribution of the intangibles to its shareholders. The Tax Court disagreed, finding that the client relationships belonged to the accountant/shareholders, individually.
Since April of 2008, several cases were decided in which taxpayers unsuccessfully attempted to apply Martin Ice Cream-type concepts.
What these Recent Cases Teach About the Personal Goodwill Strategy
Although the taxpayers lost in each of the recent cases, the Martin Ice Cream concept is not dead. Rather each of the cases illustrates a flaw in the way the taxpayers approached the strategy. The cases simply serve to illuminate the boundaries and potentials pitfalls of the "personal goodwill" strategy. They teach taxpayers and their advisors to (i) document the strategy from the beginning, (ii) be sure the facts support the strategy (iii) be sure the seller does not have a preexisting covenant not to compete and (iv) get a contemporaneous appraisal.
Document the strategy properly from the beginning. Lack of proper documentation was, to some extent, a factor in each of the recent cases. It is important to note that in every transaction using the personal goodwill strategy, it is essential that the transaction be properly documented from the start. The record should not show that the strategy was an after-thought. In addition, the documentation for the transaction should clearly identify the shareholder as the seller of the goodwill either through using separate purchase agreements for the personal goodwill and any corporate assets or using a single agreement that clearly delineates the shareholder as the seller of the personal goodwill.
Be sure the facts support the strategy. In one of the recent cases, a C corporation selling its assets was one of only two companies in a particular industry and the purchaser was the other company in the industry. The transaction involved some last minute tax planning that provided for the transfer of a customer list as part of the transaction. The final purchase price allocation included allocations of purchase price to the acquisition of covenants not to compete from the company and each of the two individual shareholders and to customer lists from the company and each of the two individual shareholders. However, there was a side agreement that contained certain material terms of the transaction, including customer notification requirements, which did not require the signature of the individual shareholders.
In reaching a decision adverse to the taxpayer, the Tax Court distinguished the case from Martin Ice Cream, providing general, continuing support for the concepts enunciated in Martin Ice Cream. The court cited several reasons for its decision. First, the side agreement required delivery of the customer lists by the corporation, without reference to any required delivery by the individual shareholders. Second, the side agreement required the selling company to transition the customers, without reference to any involvement from the individual shareholders. Third, and perhaps most importantly, the purchaser became the sole source of supply in the industry. If any customer wanted to purchase product, it would be required to do so from the purchasing company. In fact, the purchaser already knew the names of virtually all the customers.
In simple terms, the court did not think that the taxpayers had proved that they owned the customer lists. The facts simply did not support the argument that the taxpayers had developed the customer lists through exercise of their personal attributes and relationships with the customers. The personal goodwill strategy only applies where there are facts that support the ownership of the goodwill by the shareholder.
Be sure the seller does not have a preexisting covenant not to compete. In another one of the cases a District Court denied Martin Ice Cream treatment in the case of a sale of the assets of a dental practice operated in C corporation format. The case emphasizes the detrimental impact that the existence of a non-compete agreement can have on the "personal goodwill" strategy.
In the case, the taxpayer was a dentist who operated his practice as a C corporation. He was not only the sole shareholder, officer and director of the corporation but he also entered into an employment agreement and a covenant not to compete with his wholly owned corporation.
Ultimately, the dental practice was sold pursuant to an asset purchase agreement providing that the taxpayer was allocated specified amounts for his personal goodwill and a covenant not to compete and the corporation was allocated a specified amount for its assets. The IRS asserted that the goodwill that was sold was a corporate asset and that the taxpayer had received it as a dividend from the corporation immediately before the sale to the purchaser. The court agreed, framing the issue in a way that made clear that it considered the personal goodwill strategy supported by Martin Ice Cream to be a viable planning tool, despite the fact that the taxpayer lost. The case is strong affirmation of Martin Ice Cream principles. What happened in this case merely affirms what tax professionals thought all along — the existence of a covenant not to compete may negate all or a significant portion of any personal goodwill. Additionally, in affirming the case, the Appellate Court addressed an important issue that the District Court had not, as follows
Nevertheless, even if we accept the premise that the purchase agreement terminated both the employment contract and the non-competition agreement, such a release would constitute a dividend payment, the value of which would be equivalent to the price paid for the goodwill of the dental practice.
This statement raises the possibility that even if a non-competition agreement is cancelled before the existence of any purchase agreement, the cancellation could give rise to a deemed distribution triggering double tax before the sale of personal goodwill by the shareholder even occurs. The only way to avoid such treatment would be to never have entered into the covenant not to compete in the first place.
Get a contemporaneous appraisal. In still another recent case, the taxpayer had no covenant not to compete with her corporation but she stumbled on another factor. The transaction as originally agreed to by the parties set an overall purchase price and included an agreement by the seller to execute a covenant not to compete and to transition customers without any further compensation. After the tax advisors completed their review of the deal, the structure was as follows: (i) a small portion of the purchase price was allocated to the corporation's hard assets, (ii) 75% of the remainder of the purchase price was allocated to the shareholder for her personal goodwill and 25% was allocated to her for a consulting agreement and (iii) nothing was allocated to the covenant not to compete. Significantly, as it turned out, the parties did not obtain an appraisal supporting the 75/25% allocation between the goodwill and consulting services.
In its decision, the Tax Court acknowledged one of the principles enunciated in Martin Ice Cream - that "a payment to someone who provides ongoing services [does not preclude the payment from being] considered a payment for goodwill." However, the court was convinced that the payments to the taxpayer in this particular case were consideration for services rather than for goodwill. The Tax Court found that the allocation to goodwill was a "tax-motivated afterthought," and the allocation of 75% of the purchase price to personal goodwill appeared "not to be grounded in any business reality." The Tax Court also found significant that nothing was allocated to the "valuable promise not to compete." While following the pattern of previous cases by affirming the concept of Martin Ice Cream that relevant intangible assets can be owned by a shareholder, rather than by the corporation, the court indicated that Martin Ice Cream never addressed the character of taxation at the shareholder level. That is, whether the shareholder has been compensated for personal goodwill, generating capital gain, or for services or a covenant not to compete, generating ordinary income.
The most interesting and troubling aspect of the case is that the Tax Court ascribed nothing to the taxpayer's business intangible value, despite the clear suggestion in the facts that there would be some. This may have been because no evidence of value was introduced in the case. As illustrated here, appraisals in support of the personal goodwill strategy are critical. Further, the taxpayer should not wait until audit to obtain the appraisal because that could lead a court to conclude that the personal goodwill was not bargained for at the time of the transaction.
Additionally, the case illustrates that if the tax planning appears to be an afterthought, rather than part of the negotiations, the taxpayer will have an uphill battle to establish the bona fides of the separate treatment of personal goodwill in the transaction.
The bottom line is that none of the cases discussed above do anything to eliminate Martin Ice Cream - type concepts from being used in appropriate factual situations to attribute asset sale consideration to shareholders. In fact, these cases acknowledge that the concepts of Martin Ice Cream and Norwalk are as alive as ever. So Martin Ice Cream is not melting. However, the cases reiterate that the use of its concepts are fact-sensitive, and it is advisable to have a knowledgeable tax professional involved both at the time the entity is formed (e.g., to avoid noncompetition obligations to a wholly owned C corporation) and at the onset of the negotiations for sale, so that the personal goodwill concept is addressed during the negotiations and in all stages of the document preparation process. It also is advisable, for there to be a professionally prepared appraisal that values the assets being transferred by the shareholders. After all, the interests of the purchaser and the seller are not antithetical because the purchaser can amortize intangible assets whether acquired from the shareholder or the selling corporation, so an IRS challenge would not be unexpected.
Of course operating in a flow-through format from the start (as a partnership, LLC taxed as a partnership or S corporation) eliminates the need for planning to avoid double taxation. However, there are plenty of closely held C corporations still around. Also note that Martin Ice Cream - type planning not only raises its head in connection with the sale of C corporation assets, but also can be relevant where an S corporation subject to the built-in gains tax is selling its assets or selling its stock and a Code Sec. 338(h)(10) election is being made to treat the transaction as an asset sale.