August 2002

Allocating the Sale of a Business to Personal Goodwill

By Stanley E. Bulua, JD, partner, Danziger & Markhoff LLP, White Plains, N.Y.

Two recent Tax Court decisions, Martin Ice Cream Company v. Comm’r [110 TC 189 (1998)] and Norwalk v. Comm’r (T.C. Memo. 1998-279), present significant tax planning opportunities for owners of C corporations and, in certain cases, S corporations. These techniques are particularly suitable for owners of professional service corporations.

Prior to 1986, the owner of a C corporation with appreciated assets could sell the assets and then liquidate without paying a corporate-level tax. Since then, both corporate- and shareholder-level taxes are incurred upon the sale of assets in the liquidation of a corporation. This has complicated negotiations because sellers generally want to sell stock to avoid double taxation and buyers generally want to purchase assets to avoid undisclosed liabilities and obtain a step-up in basis for the purchased assets.

The selling shareholder’s objective is to reduce the total gain recognized inside the corporation, which reduces the tax liability and increases cash flow. This can be accomplished by allocating a portion of the purchase price to personal goodwill, dividing the gain on liquidation into two components: one at the corporate level and one at the shareholder level. The personal goodwill will be taxed as a long-term capital gain if the shareholder has been involved in the business for more than one year.

In both of these cases, the Tax Court held that a shareholder can own personal goodwill separate from the corporation where the customers of the business view the owner as the center of their commercial relationship. The goodwill engendered by the commercial relationship is personal goodwill that can be sold outside of the corporation, thereby reducing the double taxation imposed on the sale of corporate assets. This allocation can also reduce exposure to the built-in gains tax, which applies to an S corporation that converts from a C corporation within 10 years prior to the sale of assets.

Personal goodwill can exist only if there is no noncompete or employment agreement between the shareholder and the corporation. Otherwise, the shareholder would be treated as having transferred ownership of the goodwill to the corporation. In order to establish intent, it is critical that the corporate minutes document that the shareholder owns the goodwill separate from the corporation.

The selling shareholder should obtain a bona fide appraisal of the personal goodwill. This will help justify the amount in the event of an IRS audit. This appraisal, however, should not be prepared by the seller’s accountant.

Milton Miller, CPA

William Bregman, CFR, CPA/PFS

Contributing Editors:
Theodore J. Sarenski, CPA
Dermody Burke & Brown P.C.

David R. Marcus, JD, CPA
Marks, Paneth & Shron LLP

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