While many of the reasons for a family business to choose being a C corporation have been eliminated over the years (the deduction of shareholder health insurance, for example), there are still situations in which the limitations on S corporation ownership are an issue. However, businesses, other than personal service corporations, have another reason to consider C corporation status: In a business where the owner has a strong relationship with the customers, the C corporation structure combined with attribution of personal goodwill to the owner and not the business can result in substantial tax savings when the business is sold.
PERSONAL GOODWILL VS. PROFESSIONAL GOODWILL
The concept that personal goodwill can be a separate, salable asset, distinct from the goodwill of the business, is not new. In Thompson v. Thompson , 576 So.2d 267 (Fla. 1991), the Florida Supreme Court distinguished between personal goodwill and professional goodwill. The court indicated that personal goodwill was the value that resulted from the continued presence of a certain person, and only that person can transfer it. This principle was applied for tax law purposes in two 1998 Tax Court cases: Martin Ice Cream Co. , 110 TC 189 (1998), and Norwalk , TC Memo 1998-279. In all three cases, the question was who controlled the relationships with customers.
Several factors are considered to determine if a business’s goodwill belongs to the business or to a person. The Martin case hinged on the fact that there was no employment agreement between the company and the employee-shareholder. Therefore, the relationships that the employee-shareholder had with customers created personal, not corporate, assets. In Norwalk , the court cited the lack of an effective covenant not to compete in concluding that personal goodwill—the personal ability, personality and reputation of individual accountants—belonged to the accountants and not to their firm.
The importance of personal goodwill in the sale of assets of a closely held C corporation is significant. If the intangible is owned by the C corporation, its sale will be subject to taxation at both the corporate and the individual level, when the proceeds of the sale are distributed. Conversely, if the employee-shareholder controls the goodwill, it will only be taxed at the favorable capital gains rates; because the corporation does not own the goodwill, it will not owe any tax on its sale when the corporation is sold. The buyers will not care whether they purchase the intangible from the corporation or the employee-shareholder; in either case, it will be a section 197 asset amortized over 15 years.
When closely held businesses consider what type of entity to be taxed as, there is still a place for the C corporation. However, employee-shareholders must plan their exit strategy carefully. When properly planned, personal goodwill can result in substantial tax savings.
For a detailed discussion of the issues in this area, see “Transfers of Personal Goodwill in Sale of a Closely Held Business,” by Michael D. Koppel, CPA, PFS, in the December 2007 issue of The Tax Adviser .
—Alistair M. Nevius, editor-in-chief
The Tax Adviser
Also look for these articles in the December 2007 issue of The Tax Adviser :
“IRS Cracking Down on Government Settlements”
“Advisers Beware: The Cost of Being Sued Is Going Up”
“Employee Benefits and Pensions Update”