First of all, personal goodwill is a relatively new concept that not every legal or tax practitioner has heard of. The phrase “personal goodwill” appears absolutely no where in the Internal Revenue Code, United States Code Annotated, or any state statute. It was given life in court cases over the past 20 years and is roughly defined as “the asset that generates cash profits of the enterprise that are attributed to the business generating characteristics of the individual, and may include any profits that would be lost if the individual were not present .” Quite simply, personal goodwill is the intangible value a person (usually the owner or CEO) brings to the company. It stands in contrast to traditional goodwill in that traditional goodwill is the value attributable to the company itself arising from intangible advantages such as location, customer quality, employees, etc…. While this dichotomy may seem insignificant, personal goodwill is an important concept to legal and tax practitioners for three reasons.
Federal Tax Ramifications When selling any corporation, the buyer is always interested in purchasing the assets of a company to gain the advantage of lesser liability and the tax advantage of depreciating assets with a stepped up basis against income to reduce taxable income. While an asset sale gives rise to tax benefits to the buyer, the seller may suffer multiple tax detriments, especially in the case of selling assets of a C Corporation. With an almost certainty, in any sale, the seller will face 1) Taxes arising from ordinary income, 2) Taxes arising from depreciation recapture (also at the ordinary income tax rate), 3) Taxes arising from capital gains, and 4) in the case of a C Corporations, double taxation when the proceeds are distributed to the owners.
When selling an S Corporation, partnership, sole proprietorship, or other pass through entity through an asset or stock sale, ordinary goodwill does not present any problems. The sale of the goodwill gets taxed once, at the seller’s level as a capital asset. The tax rate on the gain is presently 15%.
However, the problems begin when selling a C Corporation through an asset sale. Ordinary goodwill creates a tremendous tax burden that is not present in the sale of a flow through entity. During the sale, ordinary goodwill is taxed at the corporate level. Since C corporations do not get the benefit of the lower capital gains tax rates, the capital gain is taxed at the corporation’s ordinary rate. This federal tax rate can be as high as 39% at certain income levels. Once ordinary goodwill is taxed at the corporate level, it is given to the seller usually in the form of a dividend distribution. When given to the seller, it is taxed at the federal dividend rate of 15%. This means that of every $100 given to the selling corporation as part of an asset sale, potentially $48 of it will be paid to the federal government as taxes. In addition, we might have to deal with state taxes.
Along comes the concept of personal goodwill. As mentioned previously, the phrase “personal goodwill” does not appear anywhere in the Internal Revenue Code. Two tax cases gave rise to the concept of personal goodwill for federal tax purposes and the two cases contain the definition for tax purposes in which we use. In the Martin Ice Cream Case (110 TC 189, (1998)), Arnold Strassberg was the co-owner of a company know as Martin Ice Cream Company. During his tenure with the company, he became a distributor of ice cream from Haagen-Dazs to multiple grocery stores under a non-written, “handshake” agreement. In the mid-1980’s, Pillsbury acquired Haagen-Dazs. Rather than allowing Arnold to continue in the distributorship, middle–man position, Pillsbury acquired Arnold’s company, the Martin Ice Cream Company. Forty-six percent of the purchase price was allocated to Arnold’s seller’s rights or what is now known as “Personal Goodwill”. When the case went to court, the Tax Court held that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the company. This landmark tax case gave rise to personal goodwill.