Personal Goodwill: A Rare Relief for Some

, New York Law Journal

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Jaipat S. Jain

Profits of a C corporation are subject to taxation at the entity-level. If distributed, they are again subject to taxation in the hands of the shareholders. In other words, the profits are subject to two levels of federal income tax.

A small C corporation is particularly sensitive to this issue in the context of sale of the business, a scenario many of the businesses engaged in professional services routinely face as owners age and seek to retire. Often, the owner has no ready, willing and able successor to continue the business. Sale of the business, then, is often the best avenue for an exit.

Sale may be structured as a stock purchase transaction, where the shareholder sells her shares of capital stock to the buyer, or as an asset purchase transaction, where the assets of the corporation are sold. Shareholders prefer selling stock: it is generally quicker because it avoids the tedium of itemizing and valuing individual assets and isolating liabilities, and, from a tax perspective, avoids entity-level taxation.

Buyers, however, generally prefer an asset purchase transaction because it lets them avoid liabilities they do not wish to assume, gives them a chance to cherry-pick assets they wish to acquire, and from a tax perspective, gives them a tax basis in acquired assets equal to the purchase price (a "step-up" in basis).1 In other words, an asset sale is generally more advantageous to a buyer and disadvantageous to a selling shareholder, particularly from a tax perspective.

In this context, an avenue for the selling shareholder to avoid entity-level taxation in certain asset-sale transactions concerns how goodwill sold in the transaction is characterized. If all or part of the goodwill sold can properly be characterized as owned personally by the shareholder of the selling C corporation, it may be possible for the selling corporation to completely avoid entity-level taxation with respect to that asset.

Since goodwill is often the largest asset of an established small business, its characterization could be a significant planning tool for business lawyers. A string of court decisions point to continued use and viability of the tool.

Transferable Personal Asset

Goodwill means "the value of a trade or business attributable to the expectancy of continued customer patronage" and "may be due to the name or reputation of a trade or business or any other factor." Treas. Reg. §1.197-2(b)(1).

For an unincorporated solo professional or other solo businessperson engaged in a practice or business in her own name, any goodwill created by her is arguably an individual asset. Could the same be applicable in a corporate setting? For nearly 100 years, taxpayers have sought to argue, often successfully, that an individual could own and transfer professional goodwill in a corporate setting.2

The most cited case for the position that a shareholder may own personal goodwill independent of the corporation even when the goodwill was created while she was a shareholder and employee of the corporation, and that she, as distinguished from the corporation, could sell it as an asset in the event of the sale of the corporation is Martin Ice Cream v. Commissioner, 1110 T.C. 189 (1998).

In Martin, the Tax Court held that the goodwill earned by the shareholder and rainmaker of an ice cream distribution business through his personal relationships belonged to him personally. The court held that because the corporation never entered into an employment agreement or covenant not to compete with Arnold Strassberg, the rainmaker, his relationships with the supermarkets and his ice cream distribution expertise never became the property of the corporation. The court held: "…personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. Those personal assets are entirely distinct from the intangible corporate asset of corporate goodwill." Martin, at 207.

'Norwalk' Reaffirms 'Martin'

Martin was soon followed by William Norwalk v. Commissioner, T.C. Memo 1998-279. Norwalk involved two accountants who, as shareholders of a corporation formed in 1985, engaged in providing public accounting services. After seven years, the corporation liquidated and distributed its assets, including "customer-based intangibles," to the shareholders. "Customer-based intangibles," according to the IRS, comprised the corporation's client base, client records, work papers, and goodwill. The IRS contended that these intangibles were corporate assets and that their distribution to the shareholders upon liquidation of the corporation triggered taxable gain. Shareholders William Norwalk and Robert DeMarta contended that they personally owned the intangibles.

In hopes of distinguishing the case from Martin, the IRS focused on the employment agreement each shareholder entered into with the corporation. The agreements contained provisions relating to ownership of confidential information and restrictions against engaging in competition with the corporation during the term of the agreement. Each of the agreements had a five-year term, and at the time of the liquidation of the corporation, in 1992, the term had already expired.

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