The U.S. District Court for the Eastern District of Washington recently held that goodwill created while a dentist was employed by his solely owned corporation belonged to the corporation and not to him. As a result, the dentist was required to characterize as a corporate dividend rather than a long-term capital gain the amount he received for the goodwill from the sale of his practice.
Goodwill is an intangible asset that represents the residual value of a business after all other tangible and intangible assets have been valued. It is created when a business can attract new customers and retain existing ones or otherwise generate earnings in excess of a fair return on its investment in tangible and other intangible assets. When deciding whether a corporation or its employee owns the created goodwill, the Tax Court, in Martin Ice Cream v. Commissioner, 110 TC 189, stated “personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation.” In William Norwalk v. Commissioner, TC Memo 1998-279, a case involving the sale of a CPA firm, the court also stated the goodwill of a professional service corporation belongs to the employees unless the employees “enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships with clients become property of the corporation.”
Larry Howard established a dental practice in Spokane, Wash., in 1972. Eight years later, Howard incorporated the practice as Howard Corp., with himself as its sole shareholder, officer and director. He also signed an employment contract that included a noncompete agreement in which he agreed not to have any involvement or financial interest in any business located within 50 miles of Spokane that might compete with Howard Corp. as long as he was a shareholder of that corporation, plus three years after ending his ownership interest. In 2002, the practice was sold to Brian Finn and Finn’s personal service corporation. Howard received $549,900 for his personal goodwill and $16,000 for an agreement not to compete with Finn, while Howard Corp. received $47,100. Howard Corp. was dissolved in 2003. Howard reported a long-term capital gain of $320,358 on his 2002 federal tax return, but the IRS recharacterized the gain as dividend income. Since dividend income was taxed at ordinary income rates in 2002, Howard was assessed a deficiency of $60,129 plus interest of $14,792.
Howard argued in district court that it was his personal goodwill that was sold, since both Washington state case law and the Finn sale agreement classified the goodwill as a personal asset. Furthermore, Howard argued, the Howard Corp. noncompete agreement was terminated by the Finn sale agreement.
The court held that the Finn sale agreement had no bearing on the goodwill ownership issue and that, even if the agreement ended the prior noncompete agreement, any goodwill would have been created before its termination. Since Howard was employed by the corporation and was bound by an agreement not to compete with it from 1980 to 2006, the court held that any goodwill created during that period belonged to the corporation. Furthermore, even if the goodwill belonged to Howard, it had little value to him, since he could not have earned any income from a dental practice within 50 miles of Spokane until after 2006, the court held.
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.
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