When your client informs you that they intend to sell their business, they may be expecting to simply collect the profits and celebrate. The unfortunate news you will have to break to them is that the tax consequences can significantly reduce their proceeds—which is why they will need a tax strategy in place before moving forward with a sale. One tactic to consider when advising on a business sale is applying the concept of personal goodwill.
Personal goodwill refers to an asset that is owned by an individual and not a business. This asset must be generated from that individual’s personal expertise or business relationships. Since this intangible “asset” belongs to the individual, its sale will be taxed as a long-term capital gain instead of ordinary income. This means that if part of the value of the business being sold can be attributed to personal goodwill, that can increase the profitability of the sale.
To better understand the application of personal goodwill, below are eight scenarios where this strategy can potentially result in tax savings:
- Sale of assets by a C corporation
When a C corporation sells assets, any gain from the sale will be taxed at 21% at the federal level, along with any state taxes. Typically, when a C corporation sells all of its assets, it liquidates and distributes the cash to the shareholder. This liquidation triggers a second round of taxation at the shareholder level. The double tax effect dramatically reduces the profits from the sale.
If you can structure the sale so that part of it amounts to an employee-shareholder selling personal goodwill, you can avoid some or all of the taxation, since personal goodwill will only be taxed once as a long-term capital gain.
- Complete liquidation of a C corporation
The case of Norwalk v. Commissioner provides an example of how personal goodwill can reduce or eliminate tax at the corporate and shareholder levels. Norwalk, a C corporation, liquidated and distributed tangible personal property to its shareholders. However, the government claimed that the company also distributed corporate goodwill valued at $588,000, which would result in a higher tax for the C corporation and the shareholders. Fortunately for Norwalk, the court ruled that the goodwill was personal, not attributable to the corporation, and no additional tax was owed.
- Failed D-reorganization
A D-reorganization involves a corporation transferring all or part of its assets to another corporation with the result that the new asset holders are now in control of the corporation receiving the assets. This occurred in the case of Martin Ice Cream Co. v. Commissioner. The question was how to compute the tax on the gain of the company whose stock was distributed. If some of that gain could be attributed to personal goodwill, that would reduce the taxes due.
- Shareholder whose stock is being redeemed
If you are redeeming a shareholder’s stock and you can pay that shareholder for their personal goodwill, the corporation may be able to amortize that personal goodwill over a period of 15 years.
- Allocating more to a working shareholder and less to a non-working shareholder
In the case of Muskat v. United States, the buyer of a C corporation paid Irwin Muskat to not compete with the buyer. Muskat was later advised by a CPA that if he had sold his personal goodwill to the buyer, he could have received long-term capital gain treatment. Using personal goodwill can reduce taxes for the seller while still accomplishing the buyer’s goal of restricting competition to the business.
- Federal or state built-in gains tax at the S corporation level
When a C corporation is being converted to an S corporation and the C corporation uses the cash method of accounting for receivables, you will face a tax on any assets that have appreciated. Personal goodwill can potentially be used to reduce this tax by attributing some of the value to the shareholders rather than the corporation.
- State gross receipts tax at the S corporation level on the sale of assets
In the state of Massachusetts, if an S corporation has gross receipts totaling at least $6 million, it will be subject to a 2% surtax. The surtax rises to 3% for S corporations with more than $9 million in gross receipts. If the gain on the sale of assets will cause the total receipts to exceed $6 million, you may be able to use personal goodwill to save that surtax. Before liquidating a business, you will want to determine if a similar tax exists in your state.
If you sell the assets at the employee-shareholder level, the proceeds will not go into the corporation. So if there is the potential for increased taxes at the corporate level, you may be able to use personal goodwill to avoid that.
- Reducing the value of closely held stock for federal gift or estate tax purposes
In the case of Franklin Adell v. Commissioner, personal goodwill was used by the valuation experts to reduce the estate tax when Franklin Adell died and saved the heirs millions of dollars.
Personal goodwill has the potential to reduce tax liability for C corporations or S corporations and on a federal or state level. To amplify your understanding of personal goodwill and other lesser-known tax-saving strategies, apply to become a Certified Tax Planner today.