More than Good Manners – Personal Goodwill May Reduce Taxes


Imagine a small business owner who is the only shareholder of an incorporated service business taxed as a C corporation by the IRS. Let’s call the shareholder “Jane” and the company “SmallCo.” Through years of hard work and dedication, Jane has built a reputation for excellent service. Furthermore, the relationships that she has forged with her customers are the reason that her company has had such success. Because it’s her company, she has never had, nor needed, an employment agreement with SmallCo.

Now imagine that all of Jane’s hard work paid off; a large corporation, “MegaCo,” wants to acquire all of the assets of SmallCo. The purchase price will be $1 million, with half of the purchase price allocated to SmallCo’s tangible assets and the other half allocated to SmallCo’s goodwill and intangible assets. In addition, MegaCo wants to retain Jane’s services after the transaction and asks Jane to sign a consulting and non-compete agreement. Jane, as sole shareholder, agrees to these terms. MegaCo pays SmallCo $1 million in exchange for all of SmallCo’s assets, and, after satisfying its liabilities, SmallCo liquidates and distributes all of its remaining cash to Jane.

As the transaction is presently structured, the sale proceeds would be subject to double taxation. First, the proceeds would be taxed at the corporate level (the difference between the $1 million received and the tax basis of the assets sold), and, second, the amount paid to Jane in the liquidation of SmallCo, less Jane’s basis in her SmallCo stock, would also be subject to tax.

Restructuring the transaction to account for Jane’s personal goodwill may reduce that double taxation burden. The Treasury Regulations define goodwill as the value of a business that is attributable to the expectancy of continued customer patronage. Generally, goodwill is an asset of the business, as reflected in the transaction structure above. Courts have recognized, however, that in certain situations the goodwill properly belongs, in whole or in part, to certain key employees of the company. This “personal goodwill” is generated by, and is directly linked to, the relationships and interactions those key employees have with the company’s customers.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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