Personal goodwill is a relatively new concept in the area of tax authority. It was given life in a recent court case. In the case, the owner of a C corporation desired to sell the business to another person by means of an asset sale. Facing the detriment of being taxed twice on all of the assets (once at the corporate level) and once at the personal level), the owner and his counsel invented the concept of personal goodwill. In a dispute with the IRS in court concerning the concept of personal goodwill, the court reaffirmed personal goodwill’s existence.Normally goodwill is attributable to the company itself, but personal goodwill is different. Personal goodwill is goodwill attributable to the owner and not the company. This type of goodwill comes through personal relations, personal knowledge, and other intangibles based on the owner of the business.
PROBLEMS WITH ORDINARY GOODWILL
When selling an S. Corporation, partnership, sole proprietorship, or other pass through entity through an asset or stock sale, ordinary goodwill does not present any problems. The sale of the goodwill gets taxed once at the seller’s level as a capital asset. The rate on the gain is presently 15%. However, when selling a C Corporation through an asset sale, ordinary goodwill potentially creates a tremendous tax burden that is not present during a stock sale. During the sale, ordinary goodwill is taxed at the corporate level. Since C corporations do not get the benefit of the lower capital gains tax rates, the capital gain is taxed at the corporation’s ordinary rate. This rate can be as high as 39% at certain income levels. Once ordinary goodwill is taxed at the corporate level, it is given to the seller usually in the form of a dividend distribution. When given to the seller, it is taxed at the dividend rate of 15%. This means that of every $100 given to the selling corporation as part of an asset sale, potentially $48 of it will be paid to the federal government as taxes. In addition, we might have to deal with state taxes.
HOW PERSONAL GOODWILL IS USED
When a seller is in the position described above, it is most advantageous to split personal goodwill off from other goodwill. During the asset allocation, assets are assigned values. There will be value given to inventory, equipment and among other things, goodwill. During this phase, the seller must include a provision stating that some of the goodwill being sold is personal goodwill. This amount should be based on a reasonable and objective estimation of the two values while keeping in mind more personal goodwill means fewer taxes, but also raises the potential of the amount being lowered on an audit by the IRS.
When appropriate, personal goodwill can provide large tax savings to taxpayers. Being a relatively new concept, it is important that the allocations to personal goodwill be reasonable and objective as there is not much guidance through cases at this point. Although personal goodwill is not a well-established concept, valuations of companies and assets are well established and can be used to value personal goodwill. The Center specializes in reducing tax burdens upon disposition of assets and liquidations of companies through the use of personal goodwill and other leading edge techniques. Call the professionals at The Center for help with the sale of your business if you are concerned about taxes.