What’s yours is yours and what’s corporate is corporate’s. Determining the difference matters in both litigation and business combinations.
In a litigation, establishing assets as personally owned or corporate owned can 1) impact the outcome in family law when negotiating the division of assets in many states, or 2) tax consideration and ownerships rights in commercial law settings.
In a business combination, taxes are the primary reason to establish the existence of personal goodwill. Personal goodwill can be beneficial to a buyer and a seller of a business. Tax professionals should be engaged to ensure optimal tax deal structures are executed.
In a transaction, a buyer may want to purchase assets in order to receive a step-up in the tax basis of the assets acquired and to minimize liability for any of the seller’s tax issues. A seller may want to execute a stock purchase to receive capital gains treatment on the purchase consideration and to maximize compensation for personal tax. If personal goodwill exists, it may benefit the buyer and the seller in the negotiation process. The buyer is allowed 15-year amortization deductions under section §197 of the IRS Code of 1986 against income for acquired personal goodwill asset. If separate and distinguishable from any corporate assets, the seller pays no corporate income tax on the sale of personal goodwill and proceeds from the sale of personal goodwill are not subject to payroll taxes.
How do you determine if personal goodwill exists?
Generally speaking, the assets on a balance sheet can be categorized as either tangible or intangible. Tangible assets include cash, accounts receivable, and inventory (current assets) as well as property, plant, and equipment (long-term assets) and are typically owned by the business.
Intangible assets are not always present on a balance sheet, but are often present and relevant in the event of a business combination or under various litigation circumstances. Intangible assets are either identifiable or unidentifiable (goodwill). The identifiable intangible assets present in a business depend largely upon the nature of its operations. The most common identifiable intangible assets that may be present include:
- Non-compete agreements;
- Employment agreements;
- Trademarks and trade names;
- Patents;
- Customer relationships;
- In-process research and development; and
- Technology.
Unidentifiable intangible assets are classified as goodwill. Goodwill can be associated with the business (corporate) or with the individual (personal). It is important to determine if the individual owning the relationships has a valid non-compete in place as of the relevant date of the litigation or transaction. If there is a non-compete, it should be determined if the agreement transfers ownership of the personal goodwill to the corporation.
In order for personal goodwill to be allowed, an individual relationship between a customer and an employee needs to exist that allows for actual tangible value between the people rather than with the brand or the business. Simply said, the customers would take their dollars and follow the individual employee should the employee leave the business and join a competitor or start their own business. It is important to emphasize that a personal relationship is a relationship with a person or persons at a business and not a relationship with the business entity itself. The details of the personal relationship between the individuals should be documented in a narrative to help support this position.
If the facts and circumstances lead to the conclusion that personal goodwill may exist, the fair market value of personal goodwill can be estimated by determining and analyzing the future cash flows directly attributable to the personal efforts of the individuals owning the relationship. Typically a valuation expert should be engaged. An income approach is the most intuitive approach to determine the fair market value of personal goodwill.
When establishing the existence of personal goodwill, valuation professionals rely on the facts and the precedent set forth in Martin Ice Cream1. In this case, the tax court held that personal relationships of an employee do not become an asset of the corporation when an employment agreement is absent. This concept was reaffirmed in Norwalk2, where the tax court stated, “There is no salable goodwill (by the corporation) where the business of a corporation is dependent upon its key employees, unless they enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships with clients become property of the corporation.”
SOURCES
1. Martin Ice Cream Co. v. Commissioner, 110 T.C. 189. 1998.
2. Norwalk v. Commissioner, T.C. Memo 1998-279.
