In the right circumstances, a taxpayer may be able to significantly reduce his/her federal income tax liability from the sale of his/her business by establishing that the buyer separately bargained for the purchase of that taxpayer’s personally-owned property (referred to herein as “personal goodwill”). This is because a sale of personal goodwill, if respected, would result in only a single taxable event, with the taxable gain potentially subject to the beneficial long-term capital gain tax rate (with a current maximum marginal tax rate of 20%).
In contrast, if there is no personal goodwill and all of the sales proceeds are received in exchange for the assets of a Subchapter C corporation, the proceeds from the asset sale would be subject to double taxation: first, at the corporate level, with the gain taxed at the applicable marginal corporate tax rate (with a current maximum marginal rate of 35%); and second, at the shareholder level upon the distribution of the sales proceeds, with the amount of that distribution generally taxable as a qualified dividend at the long-term capital gain tax rate. In addition, if there is no personal goodwill and all of the sales proceeds are received in exchange for assets of a Subchapter S corporation that was previously a Subchapter C corporation, the gain from that asset sale may be subject to a corporate level tax imposed at the highest marginal corporate tax rate under I.R.C. § 1374.
Summary of Issues
Sales of personal goodwill can be beneficial, but they can also be difficult to prove. Whether a taxpayer has sold personal goodwill in connection with the sale of his/her business is determined based on all the facts and circumstances relating to that taxpayer’s particular situation. There are many issues that must be considered in advising a client whether they have a legitimate position that they sold personal goodwill, and the following is a summary of six important issues.
1. Does the taxpayer have some personal attribute that is essential to the profitability of the target business and valuable to the buyer?
The taxpayer can’t sell personal goodwill if the taxpayer does not have any personal goodwill that a buyer would be interested in purchasing. As a result, a taxpayer must be able to substantiate that they have some personal attribute that has played an important role in the profitability of the business and that would be valuable to a prospective purchaser of that business. For example, has the shareholder developed particular knowledge, expertise, or a technique or process that is unique to the shareholder’s business? Alternatively, has the shareholder developed relationships that are essential to the profitability of the business, such as relationships that have resulted in favorable terms from suppliers or continued business from customers?
2. Does the taxpayer’s personal goodwill constitute “property” for federal income tax purposes?
This issue is relevant in determining whether the taxpayer has sold property that may be eligible for long-term capital gain treatment, as opposed to selling future services, the income from which must be taxed at the ordinary income tax rates. The outcome of this factor will likely depend on a careful analysis of the effect of federal court decisions to the client’s particular circumstances.
For example, according to the Fifth Circuit Court of Appeals, whether a transfer of an intangible asset constitutes a transfer of “property” for federal income tax purposes depends on whether the rights transferred involve the exclusive right to use property or the mere right to receive income in the future. See Bisbee-Baldwin Corp. v. Tomlinson, 320 F.2d 929, 933 (5th Cir. 1963). On the one hand, the transfer of a right to earn ordinary income in the future by the performance of personal services is not deemed a capital asset, and any amount received for the transfer of such a right is treated as a substitute for ordinary income and is taxed accordingly. See General Guaranty Mortgage Co. v. Tomlinson, 335 F.2d 518 (5th Cir. 1963). On the other hand, the sale or exchange of an exclusive right to use or possess specific property will produce capital gain. See United States v. Dresser Indus., Inc., 324 F.2d 56 (5th Cir. 1963). In addition to applying the aforementioned general standards, it is also important to determine whether court decisions exist that provide guidance with regard to the particular types of intangible assets held by the client. See, e.g., Ofria v. Comm’r, 77 T.C. 524 (1981) (trade secrets and unpatented technology constituted “property” for federal income tax purposes).
Whether a client’s particular situation will constitute the transfer of the right to use property, as opposed to the transfer of the right to earn income from the future performance of services, may involve subtle distinctions under the court decisions and require careful analysis and judgments from the client’s tax advisor. This is especially true when the business that is the subject of the sale is engaged in performing services.
3. Does the taxpayer’s personal goodwill qualify as a capital asset for federal income tax purposes?
A taxpayer who can establish that their personal goodwill constituted “property” for federal income tax purposes will be eligible for the beneficial long-term capital gain tax rate only if that property is not excluded from “capital asset” treatment under any of the exceptions listed in I.R.C. § 1221(a). There are eight categories of assets excluded from capital asset treatment under I.R.C. § 1221(a), and two of those categories that are commonly relevant are briefly summarized below.
First, the personal goodwill cannot qualify for long-term capital gain treatment if it constitutes inventory or property held primarily for sale to customers in the ordinary course of business. See I.R.C. § 1221(a)(1). According to the Fifth Circuit Court of Appeals, the determination regarding whether the taxpayer held personal assets primarily for sale to customers involves a fact intensive analysis, including but not limited to: (i) the extent and nature of the taxpayer’s efforts to sell those personal assets; and (ii) the number, extent, continuity and substantiality of the sales. See United States v. Winthrop, 417 F.2d 905, 910 (5th Cir. 1969). If the taxpayer has already sold the same type of personal goodwill in the past, then federal tax principles must be closely analyzed to determine whether the personal goodwill that would be sold under the transaction at issue could be determined to be held primarily for sale to customers. Even if the taxpayer is making a single, isolated sale, federal tax cases must be carefully analyzed to ensure that the taxpayer’s particular situation is not one that could be considered by the court to constitute a sale to customers in the ordinary course of business.
In addition, depending on the nature of the taxpayer’s personal property, it may be necessary to determine whether that property could be excluded from the scope of a “capital asset” by reason of constituting a copyright, an artistic composition, a letter or memorandum, or similar property created by the taxpayer under I.R.C. § 1221(a)(3). This issue may arise when part of the property that the taxpayer is transferring consists of written materials that could be eligible for copyright protection. Notably, the IRS has ruled that certain written items developed in the course of business activities constitute records, logs or histories that are excluded from capital asset treatment under I.R.C. § 1221(a)(3). See Rev. Rul. 82-9, 1982-1 C.B. 39.
4. Does the taxpayer have a long-term holding period in his/her personal goodwill?
A taxpayer’s personal goodwill is generally self-created over time, instead of acquired from a third party. This gives rise to the issue of what is the taxpayer’s holding period in that self-created intangible property for federal income tax purposes. Specifically, is the taxpayer eligible to report all of the taxable gain from the sale of personal goodwill as long-term capital gain, or must the taxpayer engage in some effort to allocate the gain among the proportions of personal goodwill that had been held for more or less than twelve months? Resolution of this issue may depend on whether federal courts have addressed the holding period of intangible assets in the nature of the personal goodwill transferred by the taxpayer. See, e.g., Girt v. Comm’r, 20 T.C.M. (CCH) 1499, 1501 (1961) (addressing whether the gain from transferred goodwill must be split between long-term and short-term capital gain).
5. Does the taxpayer actually own the personal goodwill, or has the taxpayer effectively transferred that goodwill to his/her business entity prior to the sale?
In personal goodwill cases, the most often litigated issue is who actually owned the goodwill before it was sold. More specifically, the common issue is whether the goodwill truly belonged to the owner, or did the owner previously assign ownership of that goodwill to the business entity so that the entity, and not the owner, sold the goodwill to the buyer.
This issue will likely be decided based on the terms of the agreements between the owner and his/her business entity. On the one hand, if the owner has not entered into any contractual obligation to continue to perform services and/or use intangible assets for the benefit of the business entity in the future, this leans in favor of the personal goodwill belonging to the owner. See Bross Trucking, Inc. v. Comm’r, 107 T.C.M. (CCH) 1528 (2014); Norwalk v. Comm’r, 76 T.C.M. (CCH) 208 (1998). On the other hand, if the owner has entered into a contractual obligation to continue to perform services and/or use intangible assets for the benefit of the business entity for a term that has not expired by the time of the sale of the business to the buyer, this would likely result in a determination that the goodwill belonged to the business entity. See Howard v. U.S., 2010 BL 370294 (E.D. Wash. 2010), aff’d, 448 Fed. Appx. 752 (9th Cir. 2011). Ultimately, the terms of all of the contractual arrangements between the taxpayer and his/her business entity must be carefully examined and interpreted in order to determine the strength of the taxpayer’s position that he/she continued to own, and had not contractually assigned, the goodwill to their business entity.
6. Did the taxpayer make a completed sale of the personal goodwill in exchange for sales proceeds from the buyer, or did the taxpayer merely license the use of the personal goodwill in exchange for royalties from the buyer?
Federal income tax authority addressing transfers of patents are often instructive in determining whether a taxpayer has sold or licensed personal goodwill. The patent authority provides the following general principles. If a transferor parts with “all substantial rights” to the patent, or an undivided interest therein which includes part or all of such rights, the transfer is a “sale” that gives rise to long-term capital gain treatment. See I.R.C. § 1235. Conversely, if the transferor retains substantial rights in the patent, the transfer is a license that gives rise to ordinary income. See Henry Vogt Mach. Co. v. Comm’r, 66 T.C.M. (CCH) 426, 435 (1993).
Thus, under these general principles, a transferor desiring “sale” treatment would ideally part with all of the rights to the personal goodwill for its entire useful life. If the transferor retains the ability to recover any portion of the transferred rights at a time at which they could still have value, the transferor runs the risk that the proceeds from the transfer of the personal goodwill will be characterized as ordinary income, rather than long-term capital gain.
This requirement that the transferor part with all substantial rights to the transferred personal goodwill puts a lot of pressure on the terms of the contracts agreed to with the buyer. If a taxpayer is interested in achieving long-term capital gain treatment from the sale of personal goodwill, it is important that the taxpayer enter into a non-compete covenant with the buyer that will prevent the taxpayer from reacquiring the use of that personal goodwill prior to the end of its useful life. In addition, it is important that none of the other agreements entered into with the buyer (such as the purchase agreement or any employment agreement) contain any provisions that would permit the taxpayer to reacquire use of the personal goodwill while it may still have utility.
7. What is the value of the personal goodwill?
A taxpayer claiming a sale of personal goodwill will also need to be able to substantiate the fair market value of the personal goodwill that was sold. If the transaction is arm’s length between unrelated parties and has adverse tax effects to those parties, the negotiated purchase price for the personal goodwill may serve as persuasive evidence of its true value. If, however, the buyer is indifferent regarding the characterization of the transaction, then the negotiated purchase price for the personal goodwill may not carry significant weight in the eyes of the IRS or a federal court. Because the taxpayer will carry the burden of proving the value of the personal goodwill in the event of IRS challenge, it is a good idea for the taxpayer to obtain an appraisal of the value of the personal goodwill from an independent expert appraiser reasonably contemporaneous with the sale of the personal goodwill.
Depending on a client’s circumstances, a sale of personal goodwill may be an effective tool for reducing the amount of federal income tax that would otherwise be owed in connection with the sale of the client’s business. As shown by the above factors, however, there are many different issues that tax professionals must address in advising a client regarding the strength of their support for claiming a sale of personal goodwill in their particular situation. In addition, tax professionals can also provide value to their clients by negotiating the terms of the transfer and drafting the related contract provisions to further support that a sale of personal goodwill has occurred. If you have any questions regarding any of the issues discussed herein, please call me at 214-749-2401.