Paul built his funeral parlor business over 44 years. Years ago, on his accountant’s advice, he incorporated and made an S-election, as do so many small businesses.

Forty-four years later, Paul was ready to sell. His active interest was worth $6 million. His cost basis in the business was almost zero.

Few buyers are interested in buying S-corporation stock, because it can unnecessarily expose them to liability. Paul’s prospective buyers wanted only the assets, not the liabilities, of business.

At first, Paul thought that he’d be stuck because his proceeds would all be inside the s-corp.

But when he met with his advisors, one of them pointed out that a significant fraction of the value of the business was actually Paul, or more specifically, Paul’s personal goodwill.

A valuation expert reviewed Paul’s business and its assets. The expert determined that half the total value of the business was personal goodwill.

And that created an excellent planning opportunity that Paul took advantage of to avoid capital gains tax when he sold.

How did that work?! We’ll explain below.

Personal Goodwill

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.

Asset vs stock purchase

Buyers often prefer to purchase assets rather than stock. Buying assets gives the buyer a basis equal to the price that buyers pay. 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 Selling a Business Advisor Guide.