As a business owner, your accounting software offers a method for tracking your tangible assets, including real estate, equipment, and inventory. However, the true value and significance of goodwill as an intangible asset may be lost if you rely solely on your accounting software. The distinction between enterprise or business goodwill and personal goodwill must be taken into account because it can play a significant role in determining the taxes due on the sale of your business. In essence, this article explores the value of popularity.
Goodwill as an Intangible Asset
The market value of a business increases when intangible assets, such as leases, trademarks and patents, and goodwill (the business’s reputation and familiarity with consumers, competitors, etc.), are added to the valuation assigned to tangible assets. The added value may significantly increase the taxes owed upon a sale of the business.
Business goodwill is a key intangible asset that represents the part of the business value that cannot be accredited to other more ascertainable business assets that would traditionally show up on the financials. Management style, reputation, recognition in the marketplace, and perhaps even SEO recognition could be considered as part of business goodwill.
Personal or professional goodwill represents the intrinsic value attributed to a particular individual instead of some characteristic of the business owned by the individual. Think Johnnie Cochran, but by no means does the person have to be famous, only well-connected in their little part of the economic world. Personal goodwill frequently takes the form of personal relationships with the business’ customers and vendors. For example, an automobile repair shop located on a busy, high-visibility corner employs a number of technicians to work on cars brought in by customers. The shop’s profits are divided equally between its two owners who are not mechanics. Around the corner is another auto repair shop hidden away on a side street that with the only mechanics being its two owners who divide profits based upon the percentage of total income attributable to each one.
If the two repair shops were to be sold, business goodwill of the shop owned by the non-mechanics would be higher than the business goodwill of the other shop. However, the personal goodwill of the owners of the shop on the side street would be substantially higher because of each owner’s personal contribution to the income realized by the business enterprise.
The benefit of personal goodwill is that it can provide tax-efficient acquisitions by lowering corporate tax upon a sale or transfer of goodwill. Since any gain on a sale of personal goodwill is generally considered a capital gain it receives a preferential capital gains tax rate as opposed to the ordinary income tax rate on income or compensation which typically is higher provided the personal goodwill is sold separately by the individual.
For an individual to sell personal goodwill, the non-tangible asset must meet the IRS definition of goodwill and be owned by the individual separate and apart from the business entity. A review of the holdings of two court cases might be helpful in understanding how to prove ownership of personal goodwill.
Personal Goodwill Ownership and Taxation
The first requirement is to establish that personal goodwill exists separate from corporate goodwill. Personal goodwill is valued solely on the personal characteristics of its business owner (see MacDonald, 3 T.C. 720 (1944)). Although extremely fact-specific and determined on a case-by-case basis, these personal characteristics can include the individual’s personal connections, ability, personality, and reputation of a shareholder-employee where a business does not have a right by contract or otherwise to that individual’s future services (see Martin Ice Cream Co.,110 T.C. 189 (1998); Norwalk, T.C. Memo. 1998-279; and Schilbach, T.C. Memo. 1991-556).
A second noteworthy requirement is that the individual possesses the right to sell the goodwill, which simply means it cannot be owned by the entity. Personal goodwill is often transferred through agreements such as employment contracts or non-compete agreements. It is important to note that once such an agreement is in place any existing goodwill or goodwill generated after likely belongs to the corporation.
For professional practices, such as dentists, medical practitioners, lawyers, and others, an employment contract can be a significant factor in determining whether the goodwill is treated as personal or business. The 9th Circuit Court of Appeals ruled in Howard v. United States that a payment to a retiring dentist was a distribution/dividend because he entered into an employment contract with himself when he incorporated his practice and executed a noncompetition agreement with the business. Howard, No. 10-35768 (9th Cir. 8/29/11). The court noted that although Howard possessed some personal goodwill through his patient relationships, the economic value of those relationships did not belong to him because he had conveyed control of them to his professional practice.
The attorneys at NM Law, APC concentrate their practice on trusts and estates and business transactions. Their practice has facilitated the transition of dozens of business, including professional practices from one generation to the next through succession planning and third-party acquisitions. Contact NM Law, APC today at (949-253-0000) to schedule a consultation with one of our business attorneys.
Disclaimer: This article is intended to provide a general summary of laws in the State of California and should not be construed as a legal opinion nor a complete legal analysis of the subject matter. Noelle Minto is an attorney at NM Law, APC in Tustin, California, a law firm specializing in Trusts & Estates and Business Transactions.