If structured properly, the seller of
personal goodwill receives significant benefits ... with no adverse tax
consequences to the buyer
December 2007 —
One of the roadblocks that commonly arises in structuring a business sale has to
do with the competing tax consequences for the buyer and seller. From a tax
standpoint, what is good for the seller is often bad for the buyer, and vice
However, one important tax strategy for sellers generally has no impact on
buyers: the allocation of company assets as “personal goodwill” of the company’s
owner or executives. In this strategy, the individual’s personal reputation,
expertise and relationships are segregated from the assets of the company being
sold. The goodwill that otherwise would be attributed to the company is shifted
to the owner/executive.
Example. If the subject company is being sold for $10 million and the
tangible assets are worth $8 million, the remaining $2 million would normally be
classified as goodwill. If that goodwill is assigned to a C corporation, it will
be taxed at the 34% rate and then taxed again, at 15%, when the proceeds are
distributed to the shareholders.
If, on the other hand, it can be shown that the goodwill is attributable not to
the corporation but to the owner/executive personally, then the $2 million would
be paid directly to him and taxed as long-term capital gain (not as ordinary
income). That keeps the proceeds out of reach of the subject company’s
creditors, if there are any. Finally, as was mentioned above, the tax treatment
to the buyer is the same regardless of whether the owner/executive recognizes
long-term capital gain from the sale of personal goodwill or ordinary income for
a non-compete payment.
Also, for some taxpayers, creating personal goodwill helps minimize corporate
income tax when the corporation liquidates, i.e., converts to an LLC that is
taxable either as a partnership or as a disregarded single-member entity. The
use of this technique can also minimize potential future built-in gain taxes if
the corporation desires to make a subchapter S election.
Background. The purposeful creation of personal good will first gained
notoriety a decade ago in what has become a famous U.S. Tax Court case,
Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998). In that decision,
the Tax Court reaffirmed that, when a corporation has no employment contract
with an employee (in this case, the owner), the employee’s personal
relationships are not corporate assets.
Here are the particulars:
Arnold Strassberg and his son, Martin, owned all of the stock of Martin Ice
Cream Co., an ice cream distributor. Before going into business with his son,
Arnold had worked for more than a decade in his own wholesale ice cream
distribution business, where he developed strong business relationships with the
managers and owners of a number of supermarket chains. Shortly after launching
Martin Ice Cream, Arnold was approached by the founder of Häagen-Dazs, who
wanted Arnold to introduce that company’s ice cream to supermarkets. On a
handshake agreement (which was never reduced to writing), Arnold quickly
established distribution relationships with four chains.
In the mid-1980s, Pillsbury acquired Häagen-Dazs and approached Arnold about
acquiring his relationships with the supermarkets so that Pillsbury could sell
Häagen-Dazs products to them directly. Pillsbury was willing to pay for Arnold's
connections but had no interest in a relationship with Martin Ice Cream or in
acquiring any of its physical assets.
Ultimately, Arnold decided to sell his relationships to Pillsbury. Then:
Arnold created a new corporation, Strassberg
Ice Cream Distributors, as a subsidiary of Martin Ice Cream.
All of the supermarket relationships of Martin Ice Cream Co. were
transferred to Strassberg Ice Cream Distributors and held as the
subsidiary’s only assets.
Martin Ice Cream conveyed all of the subsidiary’s stock to Arnold in
exchange for his interest in Martin Ice Cream.
Strassberg Ice Cream Distributors then sold the relationship assets to
Pillsbury for $1.4 million.
As part of the sale, Arnold signed a bill of sale and an assignment of
rights, and both Arnold and Martin signed non-compete agreements with
Disagreement between the Strassbergs and the IRS over how the proceeds of the
sale should be taxed ultimately led the parties to court. In its ruling in the
Martin Ice Cream case, the Tax Court attributed the $1.4 million purchase
value primarily to two assets:
Arnold’s personal relationship with the
Arnold’s handshake agreement with the founder of Häagen-Dazs.
The court determined that these assets could not be attributed to Martin Ice
Cream Co. or its subsidiary because Arnold never had a covenant not to compete
or any employment agreement with such entities.
Creating and Transferring Personal Goodwill
It is recognized in Martin Ice Cream that personal goodwill may be unique
and is present only if supported by particular facts. For example, the seller
should not be subject to a contractual non-compete provision in favor of his
former company. Further, the seller should not be subject to any
non-solicitation provision that prohibits him from contacting and trying to sell
to his former company’s customers, suppliers or service providers.
As is discussed in greater detail by Thomas O. Wells and Daniel Lampert in the
March 2005 Florida Bar Journal (“Sale of Personal Goodwill: The
Executive’s Parachute”), personal goodwill should be transferred pursuant to an
asset purchase agreement executed by the buyer and seller. The agreement should
describe the personal goodwill being transferred and include representations by
the selling individual as to ownership of such assets and that such assets do
not exist separate and distinct for the selling corporation. The agreement
should also include exhibits such as a bill of sale and an assignment of rights
(as suggested in Martin Ice Cream). The buyer may want to include any
non-compete provision within the asset purchase agreement to obtain a lengthier
presumption of reasonability for the restrictive time period. The parties may
then allocate the purchase price between assets comprising the personal goodwill
and the covenant not to compete.
Benefits. As was stated earlier, the proceeds received by the seller from
the sale of personal goodwill are subject to long-term capital gain treatment
rather than as ordinary income. (The maximum federal income tax rate for
long-term capital gains is 15%, versus 35% for ordinary income.) In addition,
long-term capital gains can be offset by capital losses, whereas only $3,000 of
capital losses may offset ordinary income each year. In Martin Ice Cream
the seller signed a non-compete agreement; the existence of this non-compete
agreement did not cause the seller’s sale of personal goodwill to be subject to
taxation as ordinary income. The non-compete agreement was seen by the Tax Court
as necessary by the buyer to protect its purchase of the seller’s personal
Tax Treatment to Buyer
Under IRC § 197, the buyer is entitled to deduct the amount paid in connection
with goodwill (whether it is personal or corporate) over 15 years. The tax
treatment to the buyer would be the same if the buyer purchased corporate or
personal goodwill or if the buyer made covenant-not-to-compete payments to the
seller in connection with the acquisition of a trade or business. Each such
asset is considered a “Section 197 intangible.” Section 197 intangibles also
include goodwill, going concern value, workforce in place, information-based
intangibles (including customer-related information such as customer lists and
patient or client files), know-how, customer-based intangibles, supplier-based
intangibles, licenses, permits, covenants not to compete, franchises, trademarks
and trade names.
A seller who has unique skills, a strong relationship with customers and an
excellent industry reputation and is not bound by a covenant not-to-compete
should consider structuring a transaction as a sale of personal goodwill. This
structure provides a seller with a beneficial parachute because the payments are
treated as long-term capital gain, not subject to equitable distribution and not
subject to the claims of the employer’s creditors. This structure can also be
used during the conversion of a corporation to an LLC or limited partnership
taxable, respectively, as a disregarded entity or partnership for federal income
If structured properly, the seller receives significant benefits with no adverse
tax consequences to the buyer.