If you have clients who own and run businesses in which they, as individuals, play an important role, they may have personal goodwill.
Identifying personal goodwill can open up valuable planning opportunities, especially for businesses that might be hard to plan for otherwise.
Goodwill is an accounting concept, as well as a real world phenomenon. Goodwill – in an accounting sense – arises when a company or business is worth more than the value of the sum of the other tangible and intangible assets. Tangible assets are assets such as property, plant and equipment. Intangible assets include intellectual property, brand names and customer lists.
Goodwill can belong to a company, such as a C-corporation, or to an individual. In either case, the goodwill can be “real world” goodwill, such as the positive feeling many people have toward companies like Coke or Apple.
Individual goodwill frequently arises in contexts of small companies where a founder has many personal relationships, and/or develops a good reputation in the community and the market.
Planning Opportunities
C-corporations typically involve double-taxation, once at the corporate level because C-corporations pay tax, and again at the shareholder level when dividends are received. Double-taxation can also arise in the context of S-corporations with “earnings and profits” or built-in gains.
This double-taxation can make it quite expensive for owners of some closely held companies to sell or otherwise take profits off the table.
Double tax on the sale of a C-corporation (or an S-corporation with earnings and profits or built-in gains) can be avoided by selling the stock. But such a sale is not always possible.
Buyers often prefer to purchase assets rather than stock. Buying assets gives the buyer a basis equal to the price paid. This basis in the assets allows the buyer to depreciate the depreciable assets, usually resulting in better after-tax results for the buyer as compared with a purchase of the stock. Purchasing assets also allows a buyer to pick and choose which assets to purchase.
Another reason buyers may prefer to buy assets rather than stock is to avoid picking up any hidden liabilities that may lurk on or off the company’s balance sheet.
If a buyer will not purchase stock, some sellers try to reduce the tax impact through alternatives including long term employment contracts, non-compete agreements, or consulting agreements. However, these are generally taxable as ordinary income, which while only one level of tax, is imposed at significantly higher rates than is capital gains tax.
When the facts permit, overall tax in a sale of assets can be reduced (and some taxes may be eliminated) if part of the sale of the business involves personal goodwill.
Case Study
We worked on a case involving the sale of a corporate business. The business assets were specialized manufacturing equipment, several parcels of real estate, and customer lists. In addition, the founder had built up a great deal of personal goodwill. His advisors were astute enough to sell the personal goodwill separately from the other business assets, though as part of the same transaction.
The total value of the assets sold was $15 million. Of that, $6 million was allocated to the seller’s personal goodwill, $7 million to the real estate, and $2 million to the equipment and customer lists.
The fact that he was able to allocate $6 million to his personal goodwill, outside of the C-corporation, enabled him to avoid an effective double tax on the personal goodwill portion, saving him approximately 20%, or $1.2 million.
Additional Planning Opportunity
Personal goodwill, as a personally owned capital asset, provides a great deal of planning flexibility. One such opportunity is to contribute, before the sale, some or all of the personal goodwill to a tax-exempt Business Owner Trust. To learn more about business owner trusts, please request our Business Owner Trust Advisor Guide. Or call 703 437 9720 and ask for Connor or Dave.