In this series, we met Brent James, the owner of Construction Services of Kansas (CSK). Brent brought a buyer’s $10 million letter of intent to an advisor whom his CPA recommended. In the course of answering that advisor’s questions, Brent explained, “CSK has some office assets/equipment (furniture, computers, and the like), but that’s about it. Everything else is all about the advice we provide to urban real estate developers regarding zoning laws, community interaction, and other issues that affect their ability to build what they want, where they want it. I guess you’d call that goodwill.” In the context of selling C corporation assets (or S corporation assets subject to the built-in gains [BIG] tax), Exit Planners certainly want to call that goodwill. Additionally, Exit Planners want goodwill to be recognized as personal goodwill for tax purposes. Goodwill attributed to an owner is considered personal goodwill.
Personal goodwill exists when an owner’s reputation, relationship with key customers, personal ability, and the like contribute to the success and profitability of the enterprise. A timely example of personal goodwill is Donald Trump and his hotel companies.
We have argued consistently that a business that is dependent on its owner is not one that holds much value for its owner. Yet, there is one possible upside to a business that is overly dependent on its ownership: Ownership-dependent businesses can be valuable when we want a buyer to pay an owner directly—rather than paying the company—for the purchase of assets. The technique we use to carve out the part of the price that a buyer pays for assets—which we want to be as large as possible—involves attributing a portion of goodwill value to the owner rather than the company.
Documenting Personal Goodwill
When a buyer pays an owner of a C corporation directly for personal goodwill, that portion of the purchase price is taxed once as a capital gain to the owner (not twice, as it is when the purchased asset is not considered personal goodwill).
When owners/sellers attribute portions of a purchase price to personal goodwill, the IRS does not get two bites of the apple. Thus, it should come as no surprise that the IRS views the concept of personal goodwill with very little goodwill. It has attacked the use of personal goodwill often and successfully. However, two recent Tax Court decisions1 have given owners and their advisors some reason to celebrate. These decisions recognize personal goodwill as an asset separate from corporate goodwill in certain circumstances. For example, the Court found that if an owner has signed a covenant not to compete with the corporation, personal goodwill is of no value, because the owner is prohibited from using his or her personal relationships, personal brand, and expertise.
Brent’s Personal Goodwill
After our fictional advisor explained to Brent the highlights of personal goodwill, he asked a few additional questions and determined that it was likely that a significant part of the business’ goodwill was due to Brent’s decades of experience, relationship building, and expertise. Brent was known and respected in his community. Like many closely held companies, Brent’s company owed almost all of its value, arguably, to Brent, not to the corporate name or the efforts of others within his company. The next step was to quantify the amount of that personal goodwill, document it, and determine how its value affected Brent’s tax bill from the sale of the company’s assets.
It is vital to document an owner’s contribution to the goodwill of a company, because the facts and circumstances of a particular situation govern the application of tax law. In Brent’s case, his advisor recruited qualified tax counsel to document Brent’s personal goodwill. That attorney brought in an experienced and credentialed business appraiser to determine the value of the personal goodwill.
The Value of “Early” Documentation
Owners, in general, are reluctant to spend money on valuations, and Brent was no exception.
“Can’t this wait until I’m ready to sell?” he asked his advisor.
“Technically, yes,” his advisor responded. “But appraisals might have more weight in Tax Court (should the IRS challenge the personal goodwill) if they are performed before a seller has negotiated the sale of business assets to an outside third party.”
“So, in addition to standing up to an IRS challenge,” Brent began, “I can use this appraisal to avoid, at least partly, the double-tax consequences on the sale of my company? Sign me up!”
Brent now understood that the appraiser’s valuation could also be used in the purchase-price negotiations between Brent and a future buyer. All assets not attributed to personal goodwill, including corporate goodwill, would be part of a separate purchase agreement. For all these reasons, it is critically important to use an experienced appraiser to properly document and categorize personal goodwill.
Exit Planners Beware
We’ve just covered a lot of tax law and survived. Technical concepts, such as personal goodwill, require those of us who aren’t tax experts to have those experts on call. We believe that it’s important for Exit Planners to be able to explain technical concepts and recognize that there may be tax solutions with which the owner and his or her regular advisors are unfamiliar. We should also remember that, as Exit Planners, our efforts to maximize post-sale after-tax proceeds for our clients can cause us to lose focus of our purpose: to meet our clients’ ultimate Exit Planning goals. We can’t let the tax tail wag the dog—either our clients’ or ours.
In other words, if an owner’s Exit Path involves double taxation but that Path achieves all of his or her other goals, it may be the best Path for that owner. It is possible that an owner’s desire for an immediate exit outweighs any tax advantages of waiting to sell while engaging in tax planning. Our job as Exit Planners is to make sure that an owner’s choice is an informed one.
Brent Makes His Choice
If Brent, perhaps like many of your clients, insists on selling now, he still has alternatives that can reduce the amount of the double-tax recognition. The two biggest are as follows:
- Make an S corporation election and, through proper valuation, attribute as much of the value as possible to post-conversion growth.
- Determine the amount of personal goodwill, if any, subject to a single capital-gains tax at the ownership level.
Owners of C corporations can use these and other techniques and designs to reduce the overall tax consequences of an asset sale.
The tax strategies that we’ve described in this article (and series) are general, which means that they are not appropriate in all circumstances. All Exit Planning Advisors should rely heavily on the knowledge of the tax experts in their advisor networks. These experts are used to design specific tax-minimization plans for each unique client situation. Rather than attempt to make you a tax expert by describing (in exhaustive detail) all available tax-mitigation strategies, we hope our articles alert you to the numerous opportunities owners have if they engage in planning 5–10 years before their planned departure dates. As this article and others demonstrate, your clients may save millions of dollars through planning and timely execution.
C corporation owners are generally unaware that most third-party sales are asset sales and, without planning, they’ll pay taxes twice. Some advisors are not tuned to the fact that their aging clients may one day exit their businesses, are unaware of the double-tax trap, or don’t feel it is their responsibility to discuss possible sale consequences and planning with their clients.
This opens the door for Exit Planners to do the following:
- Identify existing and prospective clients who own C corporations, which comprise more than 1 million corporations in the United States.
- Engage owners in conversations about their plans to eventually leave their businesses.
- Describe (in general terms) the likelihood and the consequences of selling corporate assets.
- Maintain communication with owners regarding tax-minimization and other Exit Planning concepts, issues, and benefits.
Next week’s article will describe several approaches designed to persuade a buyer to forego the benefits of an asset sale and agree instead to a stock sale.
If you would like to learn more about personal goodwill, go to this link to contact us today!
1. Bross Trucking, Inc., T.C. Memo. 2014-107, and Estate of Adell, T.C. Memo. 2014-155. See more at http://www.thetaxadviser.com/issues/2015/apr/tax-clinic-07.html#sthash.