By Asif Charania, CPA, ABV, ASA | Valuation and Forensic Services Manager
A transaction involving the sale of a corporation with appreciated assets can result in a significant tax liability for the seller. However, through proper tax planning, the potential tax liability may be significantly reduced by allocating a portion of the fair market value of the assets to the personal goodwill of the seller. Accordingly, a transaction involving the transfer of personal goodwill to a prospective buyer will result in capital gains treatment to the seller.
Factors supporting the existence of personal versus entity goodwill are as follows:
- Selling shareholder is actively involved in the business
- Loss of selling shareholder would materially impact the operations of the business
- Lack of a non-compete agreement for selling shareholder
- Existence of key man life insurance policies
- Selling shareholder possesses primary relationships with customers and is the primary “rain maker” in the business
- Customer base is small and concentrated
- Lack of contracts with customers or contracts that are terminable at will
- Business is highly technical or a professional service
- Company maintains market share despite significant competition
- Selling shareholder is passive with respect to the operations of the business
- Loss of selling shareholder will not materially impact the operations of the business
- Non-compete agreement/employment agreement exists for key shareholder of the business
- Strong depth of management and formal organizational structures
- Existence of brand recognition
- Diverse customer base
- Asset intensive businesses
- Lack of competition
- Market share maintained through patents or other know-how
The existence of a non-compete and employment agreements significantly impacts the distinction between personal and entity goodwill. Typically, agreements that exist prior to a transaction have the impact of transferring personal goodwill to the entity. However, agreements entered into during the transaction process support the allocation to personal goodwill.
Sale of Personal Goodwill
Given that personal goodwill is an asset of the seller, two separate transactions should be executed when consummating a transaction: 1) the sale of corporate assets, and 2) the sale of personal goodwill of the selling shareholder. In addition, any personal goodwill must be both salable and transferable. Accordingly, a seller should enter in a covenant not to compete with the buyer simultaneously during the sale of corporate assets, which serves to transfer the seller’s personal goodwill to the buyer. As a result, the proceeds from the sale of personal goodwill is taxed at the favorable capital gains rate rather than treated as ordinary income to the seller.
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.