Three Requirements for Using Personal Goodwill to Reduce Taxes

What does personal goodwill have to do with the sale of a business? Business owners looking to maximize their profits from selling their shares or assets will need a strategy to reduce the tax consequences. This is especially true for the sale of a C corporation since this business type is taxed separately from its owners. When a C corporation sells assets, that gain is taxed once at the corporate level and again at the shareholder level. This can dramatically reduce the profits of that sale.

One strategy is to attribute some of the gain to personal goodwill—this refers to an asset generated from an individual’s personal expertise or business relationship. Because this asset is owned by an individual and not a business, it will be taxed at a lower rate (as a long-term capital gain instead of ordinary income). This means that establishing the existence of personal goodwill can increase the profitability of a business sale.

A close look at the court cases that have shaped tax law points to three main prerequisites for the use of personal goodwill:

  1. You cannot have a covenant not to compete between the employee-shareholder and the corporation in which that employee owns stock.
  2. If there is a covenant not to compete, there also cannot be an employment contract.
  3. You must have facts establishing a close, personal relationship between the employee-shareholder and the customers of the business.

Covenant Not to Compete

In the case of Larry Howard v. United States, Howard had a covenant not to compete between himself and his wholly-owned corporation. When his C corporation sold its assets, the company realized that they would get hit with taxes at both the corporate and shareholder levels. So Howard decided to sell his personal goodwill to the buyer in an attempt to reduce the taxes.

Unfortunately, his covenant not to compete invalidated that approach. Normally, when the company sold its assets, this would have included corporate goodwill. When Howard attempted to also sell his personal goodwill, the court determined that this was not allowed because he had signed a covenant not to compete with his own corporation.

In certain states, such as Massachusetts, law firms cannot have covenants not to compete with their associates. The concept behind this is that the client has the right to decide who represents them regardless of which firm they are currently working for. This does not hold true for other sectors, such as accounting firms, where covenants not to compete are common and can impact the use of personal goodwill. Check the specific rules in your state when evaluating whether you meet this requirement.

Employment Contract + Covenant Not to Compete

In addition to a covenant not to compete, an employee shareholder may also have signed an employment contract with the corporation they own. In the litigation that has occurred to-date, use of personal goodwill has not been allowed if the employee has both an employment contract and a covenant not to compete. However, if only an employment contract exists, no precedents seem to indicate that you cannot use personal goodwill.

Close, Personal Relationship with Customers

In the case of Norwalk v. Commissioner, the owners of a C corporation that provided accounting services completely liquidated the company and joined an existing partnership. Two of their accountants followed them to the partnership, bringing with them 92 of their clients. This is a clear illustration of the concept of personal goodwill: if you, as an employee-shareholder, left the company today, would your customers follow you? The existence of that close, personal relationship amounts to personal goodwill that has been built over years by these individual accountants by providing quality service to their clients.

Personal goodwill is most likely to exist in personal service businesses, such as health care, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting. The use of personal goodwill may not be limited to these fields, but the key is that the employee is an owner or shareholder in the business and has established those close relationships with their customers.

One note to consider is that the popularly-used Section 1202 tax exclusion for “qualified small business stock” may not be compatible with the use of personal goodwill. Eight types of personal service businesses are excluded from using this tax break—while those businesses are likely candidates for personal goodwill, they would not be “qualified small businesses” as defined by Section 1202.

Summary

Employee-shareholders who are looking to reduce taxes on the sale of their business or certain assets might consider the use of personal goodwill if they meet the three key requirements. The employee-owner cannot have a covenant not to compete with their own company or an employment contract in conjunction with a covenant not to compete. The seller must also be able to demonstrate close, personal relationships with the customers of the business in order to claim personal goodwill.

For further guidance in determining whether you can use personal goodwill in your business sale, reach out to a Certified Tax Planner today.

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