16 Oct Personal Goodwill: A Means For Reducing C-Corp Sale Taxes
What value do you personally bring to your business? More precisely, what impact would your departure have on the performance of your business? Would it suffer without you or could you be easily replaced?
This is more than just a rhetorical question because the answer is proving pivotal in C-corp sale transactions and divorce litigation settlements.
The concept of personal goodwill has been around for more than 50 years in our court system, mainly as it pertains to the separation of marital assets in divorce proceedings. Most state courts have, over the years, held that the portion of a company’s value that can be attributed to the owner-manager is not to be considered a divisible marital asset. This means that the owner-manager’s spouse is not entitled to a portion of this asset.
Recently, however, as the result of rulings in court cases such as Martin Ice Cream and Cascade Designs, the personal goodwill concept has been used as a means to reduce taxes in C-corporation business sales. In short, if a portion of a company’s goodwill can be found to actually reside with the owner-manager himself or herself, then the company cannot sell this asset that it does not own. The services, talent, cooperation, experience and know-how of the owner-manager must be purchased directly from the owner-manager. By doing so, the buyer pays money directly to the owner-manager, thereby averting the double taxation that occurs on payments to the C-corporation.
Is a part of the value of your business actually owned/held by you in the form of personal goodwill (P), or is the goodwill value substantially with the business (B)? The questions below were adapted from those published by Rod Burkert in “Separating Personal and Business Goodwill of Operating Companies in Divorce Valuations.” Circle “B” or “P” based on which is substantially true for your business. If you circle a preponderance of P’s, then a portion of the total value of your business might actually reside with you. If you circled a preponderance of B’s, then the value of your business may reside mostly within the business itself.
Type of Service
- Is the product creation process labor intensive (P) or machine intensive (B)?
- Are orders received by the owner and/or his staff (P) or automatically (B)?
- Do customers interact with the owner-manager personally (P) or mostly just with employees (B)?
- Do customers associate quality with the owner-manager (P) or with the company (B)?
- If a reputation of quality, honesty and fair dealing exists, is it attributed to the owner-manager (P) or the business (B)?
- Do customer referrals come to the owner-manager personally (P) or to the business (B)?
- Do the customers speak of the owner (P) or the business (B)?
- Does most revenue come from repeat business (P) or new customers (B)?
- Are there just a few customers (P) or many (B)?
- Start-up (P) or mature business (B)?
- Is the business named after the owner (P) or not (B)?
- Is there one owner working in the business (P) or many (B)?
- Does the owner-manager handle all core tasks (P) or delegate them to a talented team (B)?
- Are the systems, processes and methods “in the owners head” (P) or are they documented and carried out by others (B)?
- Does the owner work many hours in or on the business (P) or few (B)?
- Is the owner well known in the industry and community (P) or not really (B)?
- Does the business require a high level of knowledge, skill and ability (P) or could the business be run by any one of a great many people (B)?
- Can personal relationships influence customer decisions to buy (P) or are customers largely interested only in price, terms and service quality (B)?
- Is the business financing personally guaranteed by the owner (P) or not (B)?
- If the business was purchased, was a covenant not to compete a part of the terms (P) or not (B)?
- Can the ownership interest be sold without restrictive covenants on the owner (B) or would the buyer likely require the seller to agree to restrictive covenants (P)?
- Would the loss of the owner’s services result in a decline in revenue (P) or not (B)?
To be sure, personal goodwill can only exist if the business contains value over and above the tangible assets of the business. This can be demonstrated as follows:
Total Business Value – Net Tangible Assets = Intangible Assets
Intangible Assets = Business Goodwill + Personal Goodwill
A business has value in excess of its net tangible assets (cash, receivables, inventory, fixed assets, other tangible assets, minus total liabilities) to the extent that profits, or projected profits, establish to a degree that buyers will pay a price for the business that exceeds the value of the net tangible assets. When this is the case, the task will turn to determining a proper allocation of the goodwill value between business and personal.
The purpose of this article is to introduce you to the concept of personal goodwill. If you find yourself in a divorce or C-corporation situation and you think that a portion of the value of your business might reside with you personally, investigate the subject with a trained and experienced business appraiser.
What is more desirable? It depends on your vantage point. For example, it might be flattering to you if your business was dependent on you and the goodwill was held by you personally. If this was the case and you were selling a C-corporation, you might be able to avoid double taxation on a portion of the business value. In contrast, you might be most proud if you built a business that could run, profitably, on its own, and possessed little or no personal goodwill. Be clear, however, that it is harder to sell a business in which the owner is active in the business and, even more so, was hard to replace. Furthermore, such a business will command a lower price.
“Valuation of Personal Goodwill,” R. James Alersing
“Separating Personal and Business Goodwill of Operating Companies in Divorce Valuations,” The Tax Adviser, June 2003 edition
“Separating Personal and Business Goodwill of Operating Companies in Divorce Valuations,” Rod P. Burkert
“Personal Goodwill – The New Frontier,” Alerding and Karam, 2003