Personal Goodwill in a Merger & Acquisition Transaction

Summary:

• When a business is sold as an asset sale, a separate sale of a shareholder’s personal goodwill associated with the corporation can result in the gain from the sale of the goodwill being taxed to the shareholder at long term capital gains rates.
• Personal goodwill can be present when the owner’s reputation, expertise, skill, knowledge, and relationships with customers and/or suppliers are critical to the business’s success and value.
• Personal goodwill may be deemed an asset of the corporation where shareholders have transferred the goodwill to the corporation through noncompetition, employment or other agreements with the corporation.

Selling a business can require some of the most important tax planning an owner may ever need. This is particularly true when a business that has operated as a C corporation is sold as an assets sale. In this situation, the owner may be able to significantly reduce his/her tax liability on the sale of the business by selling his/her personal goodwill associated with the business separately from the business’s assets. However, to ensure a sale of personal goodwill, an owner needs to take steps before the sale transaction to establish the existence of personal goodwill and that it has been separately transferred.

A taxable sale of assets, followed by a distribution of the sale proceeds to shareholders, normally results in a double tax at the corporate level and the shareholder level. While double taxation can be avoided if the transaction is structured as a stock deal, purchasers often prefer asset deals for three main reasons:

1. In an asset deal, the purchaser gets a stepped-up, fair market value basis in the acquired assets equal to the price paid and any liabilities assumed (Purchase Price), and will therefore get a higher depreciation and amortization deductions.
2. Unlike in a stock deal, which takes the target corporation with all its liabilities, known or unknown, an asset deal allows the buyer to select which liabilities, if any, it will assume.
3. An asset deal allows the buyer to select which assets it will purchase, rather than, as in a stock deal, all of the target corporation’s assets, wanted or unwanted.

Few strategies are available to avoid double taxation under an asset deal. The most frequently used strategies involve payments directly to shareholders under employment, consulting or noncompetition agreements. However, those payments, while only taxed once, will constitute income and be taxed an ordinary income tax rates. That why a strategy that involves a shareholder’s sale of personal goodwill could be beneficial. For the strategy to work, it must be demonstrated that goodwill in fact exists, that it is both salable and transferable to the buyer of the target corporation (meaning that in the absence of a covenant not to compete with the buyer, there can be no transfer of goodwill), and that it is personal goodwill owned by the shareholder rather than business goodwill owned by the corporation itself (meaning that there is no existing employment or noncompetition agreement with the target corporation).

Summary of Tax Implications:

A sale of personal goodwill creates long term capital gain to the shareholder, taxable at up to 23.8 percent rather than ordinary income to the target corporation of 21.0 percent (excluding state and local income taxes that can range from 1% to 12%) and an additional tax of up to 23.8% on the balance of the transaction price distributed by the target corporation to the shareholders. In other words, the income tax is potentially almost two times as great (45% vs. 23.8%) if the sales proceeds are made first to the target corporation rather than to the individual shareholder. 

Planning Considerations:

Planning for the sale of personal goodwill should begin well before a sale of the target corporation is contemplated.

1. Review all corporate records to ensure shareholders have not transferred ownership of their personal goodwill to the target corporation, either through a capital contribution or by entering into a long term employment or contribution agreement.
2. At the inception of a contemplated asset sale, make clear to the prospective buyer that the target corporation owns tangible assets, while the shareholders own the personal goodwill associated with the business operations. Any confidential agreements of the prospective buyer should be addressed to both the target corporation and its shareholders as sellers.
3. Any letter of intent should contemplate two separate, but related, asset sale transactions – one for the target corporation’s tangible and intangible assets and the other for the shareholders’ sale of their personal goodwill. 
4. The two contemplated asset sale transactions should be set forth in two separate, but related, definitive agreements. Each definitive agreement should contain the noncompete covenants to the shareholders and should clearly state how the shareholders will sell and transfer their personal goodwill to the prospective buyer.
5. There should be two separate bills of sale under which the target corporation and the shareholders will transfer title to the respective assets to the buyer.

Quantifying Personal Goodwill:

There are a number of methodologies used to quantity personal goodwill.

• With vs. Without Approach – this method calculates the business enterprise value of the company with and without the key individual that is expected to have personal goodwill. This approach determines the amount of income that would be lost if efforts of the key individual ceased or if the individual were to compete with the company directly.
• Bottom-Up Approach – this method is similar to a standard purchase price allocation analysis. It allocates value of the business enterprise to both tangible and intangible assets and any remaining value is attributable to personal goodwill.
• Top-Down Approach – This method values the business enterprise, but then uses a qualitative approach, such as a Multi-Attribute Utility Model, to separate personal goodwill from enterprise goodwill. Various attributes of personal goodwill are identified and then weighted based on 1) the importance of the attribute to generating cash flow, and 2) the degree to which the factor exists.

If structured properly, the seller of personal goodwill can receive significant tax benefits. However, allocations of personal goodwill must be reasonable and objective. 

Quist Valuation has over 35 years of experience working with business owners and has the experience and credentials to perform appraisals of personal goodwill.