We have encountered more situations where clients who have sold a business or assets have claimed a portion of the purchase price as personal goodwill. The tax savings for the individual assigned the personal goodwill can be significant. If personal goodwill is not a property right of the enterprise, its value is not includable in the assets of the business. Thus, it is separable from business goodwill.
What is personal goodwill? It is that portion of total goodwill that is directly attributable to key employee functions in the business. Critical to this separation from business goodwill is the ability of the evaluator to articulate specific examples that quantify how the key employee is responsible for producing business profitability. These examples can explain how a portion of the profits are solely attributable to him or her. It is more than merely showing that any competent, qualified employee could perform in the same position. The analysis must be specific to the key employee.
Possible Splitting of Goodwill
The determination to split business and personal goodwill arises whenever tax consequences or economic benefits result from a specific transaction. These include:
- Corporate Asset Sale – IRC Section 331 requires a recognition of gain or loss from an entity liquidation. To the extent that goodwill exists, the amount attributed to the shareholder (versus the company) reduces any gain subject to corporate level tax.
- Installment Sale – For a C corporation liquidation, Section 453B allows for shareholder goodwill to be deferred and reported by the shareholder as received.
- Deemed Asset Sale – Includes a conversion of an operating corporate entity into a proprietorship, partnership or LLC; and a qualified stock purchase treated as an asset acquisition via a Sec. 338 election. In a 338, the seller has sold stock but the buyer may elect an asset purchase.
- C to S Conversion – May create corporate goodwill. Overall limit of the tax is the net unrealized built-in gain (NUBIG) at date of conversion.
The landscape of court cases is favorable to the taxpayers taking advantage of the separation of personal from business goodwill. At the same time, the analysis supporting personal goodwill must withstand both intense IRS and Tax Court scrutiny.