Often times in the sale of a business, a portion of the purchase price is allocated to goodwill. What is goodwill? "Goodwill is the value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor."[1] Goodwill is a capital asset that is subject to favorable capital tax treatment to the owner. The Courts have found two (2) types of goodwill: (1) personal goodwill developed and owned by the shareholder or key employee, and (2) corporate goodwill developed and owned by the business entity. The proper tax treatment of the sale of goodwill depends on how the business entity is structured and what agreements, if any, the professional or key employee has with the business entity. The determination of the ownership of the goodwill, whether owned by the corporate entity (i.e., corporate goodwill) or by the employee (i.e., personal goodwill) and the valuation thereof, are dependent on the facts and circumstances and is determined on a case by case basis.
Goodwill was determined to be owned by the key employee, and not a corporate intangible asset, where the business of the corporation is dependent upon its key employee and the employee has no employment agreement or covenant not to compete with the corporation.[2] In Martin Ice Cream, the key employee built the business of distributing super-premium ice cream to supermarkets based on his personal relationships with the supermarket owners and with his personal understanding with the founder of the super-premium ice cream. The key employee did not enter into an employment agreement or a covenant not to compete with his corporate employer nor did he assign any of his rights in his relationships with the supermarkets to the corporate employer. In supporting its finding of personal goodwill, the Tax Court noted that the Court had long recognized that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation,[3] and that "the personal ability, personality, and reputation of sole shareholder are not a corporate intangible asset where there is no contractual obligation to continue the shareholder's services."[4]
In the most recent case of Boss Trucking, Inc.,[5] the issue was whether the corporation distributed corporate goodwill to its key employee-shareholders who then gifted that asset to his three (3) sons. The Court determined that the goodwill belonged to the key-employee shareholder (i.e., personal goodwill) based on the following facts:
- The key employee-shareholder did not have an employment contract with the Corporation nor a no-compete agreement that would prohibit him from competing against the Corporation
- Nearly all of the corporation's patronage was solely because of the relationship with the key employee-shareholder
- The key employee-shareholder had close, personal relationships with owners of the Corporation's primary customers
- The key employee-shareholder was successful in the business and was in the industry for over 30 years
- The continuing patronage was due to the key employee-shareholders unique relationships with the customers and not due to the Corporation's products or services
In both Martin Ice Cream and Boss Trucking, the absence of an employment agreement and a covenant not to compete by the key-employee shareholder supported the Courts' determination that the goodwill was not corporate goodwill and was the personal goodwill of the key employee-shareholder. Other factors which supported the finding of personal goodwill in these cases were the key employee's personal and unique relationships with the primary clients of the business.
The second type of goodwill is corporate goodwill which was found in Howard v. U.S., No. 10-35768 (9th Cir. 2011). Unlike Martin Ice Cream and Boss Trucking, the key employee-shareholders in Howard entered into an employment contract in which he agreed to provide services solely as an employee of the Corporation and agreed to devote his entire profession to the Corporation. The key employee-shareholder consented to the Corporation's retention of complete control and authority in accepting or refusing clients and for all files and other records to be owned by the Corporation. The key employee also entered into a non-compete agreement in which he agreed to not compete with the Corporation for a period of three (3) years. Because the key employee in Howard relinquished and assigned all control and authority to the corporation, goodwill was determined to be owned by the Corporation.
As the foregoing cases show, the determination of the ownership of goodwill depends on many different facts and circumstances. The tax effects from the sale of goodwill depend on the ownership of goodwill.
If you're planning on buying or selling a business or in the process of selling your business, call our office to schedule a meeting to discuss the impact of the ownership of goodwill in your transaction.