Allocating a portion of the proceeds from the sale of assets of a closely-held private company to the personal goodwill of a major shareholder can confer significant tax benefits for both parties to the transaction.

For the selling shareholder(s) and corporation, significant tax savings can be available.

For the buyer, a structure with the acquisition of personal goodwill can make the transaction more attractive to the sellers.

But while regulators and courts long ago blessed the fundamental concept of personal goodwill—that some portion of the overall value of an enterprise may belong to an individual shareholder rather than to the company itself—they have historically set a high bar for those who wish to claim it.

Participants in a transaction that may qualify can ask a series of questions to ascertain whether their deal could include personal goodwill and, if so, can take proactive steps as the sale progresses to document its existence in the event they later need to prove their case.

What is Personal Goodwill?

Personal goodwill is an asset that is owned by an individual, not the business itself. It is generated from the personal expertise or business relationships of an individual employee or shareholder.

Statutorily, it relies on §1.197-2(b)(1), the section of the tax code that defines goodwill in general. For its part, the Internal Revenue Service acknowledged the existence of personal goodwill and offered some guidance on its thinking in a 2002 technical advice memorandum (TAM 200244009).

A number of legal cases have further defined the appropriate application of and limits on those who would claim personal goodwill in connection with the sale of a private company. These cases include:

• Martin Ice Cream Co. v. Commissioner
• Norwalk TC Memo 1998-270
• Solomon TC Memo 2008-102
• Muskat v. United States
• Estate of Adell v. Commissioner, TC Memo 2014-155
• Bross Trucking, Inc. v. Commissioner

Why Bother? Consider the Tax Treatment of Personal Goodwill

For the seller, among other things, attributing a portion of the proceeds to personal goodwill can reduce the overall tax liability associated with a liquidation because that portion will be treated as long-term capital gains instead of ordinary income.

Figure 1 is an illustrative example of the tax savings available for transactions that are structured as asset sales where personal goodwill assets are recognized.

The left column shows the federal tax treatment for the sale of a closely held private company at a fair market value of $5.0 million without personal goodwill. Assuming a corporate tax basis of assets of $1.0 million and a shareholder basis in the company of $1.0 million, the result is a total corporate and shareholder tax liability of $1.472 million, for an effective federal tax rate of nearly 30 percent.

It is important to note that in an asset sale, the proceeds are double-taxed: first, the corporate-level gain on the sale of assets and, second, the shareholder-level on their basis in the company.

The right three columns show the federal tax impact for the transaction with recognition of personal goodwill.

The gain on the sale of the corporate assets (valued at $3.0 million) is still double-taxed; however, personal goodwill (valued at $2.0 million) is taxed only at the shareholder’s long-term capital gains rate.

In this scenario, recognition of personal goodwill reduces the value of corporate assets, thereby lowering the taxable gain to the corporation. This results in an estimated corporate and shareholder tax liability of $1.136 million, representing an effective federal tax rate of 22.7% and a tax savings of $336,000.

Beyond the federal tax savings, there are other compelling reasons for a seller to treat part of a sale as personal goodwill, if possible:

• Creditors of the company cannot look to personal goodwill to satisfy debts
• It can serve to reduce entity-level state income and other taxes
• Buyers may prefer, and thus may pay more for, assets vs. stock given the stepped-up basis the assets receive

What Are the Requirements of Personal Goodwill?

It is clear that ascribing part of the sale of a closely held company to personal goodwill has advantages—that is one reason why the IRS and the courts closely scrutinize any seller who wishes to assert it.

Would-be personal goodwill claimants need to show:

1. It exists
2. It has a quantifiable value
3. It is owned by the shareholder and was conveyed to the buyer

It exists. In some of the case law surrounding personal goodwill, litigants attempted to assert personal goodwill very late in a sale process—or in some cases even afterward, in an amended tax filing.

A claim of personal goodwill has a much better chance of withstanding scrutiny if it is asserted and documented early in the discussions of a transaction and both sides acknowledge personal goodwill as a feature of the deal.

Stronger support for the identification of personal goodwill generally exists when the following conditions are met:

• The shareholder(s) are highly involved in day-to-day company operations;
• Intangible assets drive a significant portion of total company value;
• There are limited contractual arrangements with customers and/or suppliers; and
• The shareholder(s) have a strong professional reputation, deep personal relationships with customers, suppliers, or employees, and/or superior technical skills and expertise.

It has a quantifiable value. It can be extremely beneficial to seek a third-party opinion on the value of personal goodwill. There are two broadly accepted approaches and valuation providers may use one or both methods when valuing personal goodwill.

The loss-of–income method, or “with-without analysis,” seeks to isolate what would happen to cash flows both with and in the absence of the claimant’s personal expertise and/or relationships. Cash flow impact could be due to reduced revenue or increased expenses in the absence of personal goodwill. The sum of the present values of the incremental cash flows is treated as the value of personal goodwill.

The residual method, on the other hand, entails calculating and subtracting the value of all tangible and intangible company assets from the enterprise’s nominal value and attributing the remainder to personal goodwill. This can be a more cumbersome approach and still may not differentiate between the company (enterprise) versus personal goodwill.

Practitioners frequently employ a multi-attribute utility model to discern corporate goodwill versus personal goodwill and will often build a file that includes awards, news articles, and other forms of industry recognition to support the case that the shareholder claiming personal goodwill is indeed a prominent and unique figure in their industry.

It is owned by the shareholder and was conveyed to the buyer. In most cases, shareholders who successfully claim personal goodwill are not operating under strict employment agreements and have not entered into a covenant not to compete prior to the transaction.

Courts have generally found that any value created by those who have entered into such binding agreements belongs to their company and, thus, is not the shareholder’s property to sell. (On the other hand, an employment agreement and non-compete entered into with the acquirer as part of the transaction can serve to bolster an assertion of personal goodwill, as it corroborates the idea that the individual in question is a significant and unique source of value.)

Finally, in addition to referencing personal goodwill in the deal negotiations, it is a best practice to formally recognize it with separate purchase agreements and/or distinct purchase prices within an agreement—one for the purchase of the company assets and one for the purchase of the personal goodwill asset of the shareholder.

Summary

Under the right circumstances and with the right planning, personal goodwill can offer significant benefits to the seller and buyer of a closely held company. But in pursuing the quarry, caution is warranted, as it must be identified early, precisely quantified, and carefully documented.

After all, the game wardens will be watching closely.

For a more in-depth conversation on this topic, we welcome you to contact the article author, Doug Peterson, or a VRC team member.