How Personal Goodwill Can Avoid Double Taxation

Question:  I have been advised that personal goodwill can help me avoid the double tax that will result when I sell my C corporation assets.  Is this true?

Answer:  Many businesses are operated through corporations which are treated as separate taxpayers for Federal income tax purposes and pay tax on their income.  One of the hurdles that these C corporations face is the double taxation which arises when the business sells its assets.  C corporations pay tax on the gain from the sale of their assets while the distribution of the sale proceeds from the corporation to its shareholders is taxed again, thereby giving rise to the second layer of tax.

One strategy for mitigating the harshness of double taxation on C corporations is identifying personal goodwill of a controlling shareholder.  The U.S. Tax Court has held that in appropriate circumstances, the personal goodwill of a majority shareholder is an asset separate and distinct from the assets of the corporation itself.  It follows that any consideration received by the selling shareholder from the purchaser which is attributable to the selling shareholder’s goodwill is reportable as income on the selling shareholder’s personal income tax return, not on the tax return of the C corporation.  Not only will the gain attributable to personal goodwill avoid the double tax trap, but the income reportable by the shareholder will be treated as a capital gain which is taxed at a lower rate than ordinary income.

Establishing and supporting the position that personal goodwill has been sold requires more than simply labeling consideration received as personal goodwill in the purchase and sale agreement.  The selling shareholder must be engaged in a relationship-oriented business where his or her personal contacts make a significant contribution to the success of the business.  The selling shareholder must be more than just a business operator and should be actively dealing with third parties who have an important connection to the business.  The absence of a contractual relationship of the business owner with the C corporation lends further support for personal goodwill treatment.  The controlling shareholder must not have a covenant not to compete with the selling corporation as this arrangement suggests that the selling shareholder can only be acting on behalf of the corporation, not on behalf of himself or herself in dealing with third parties.  Also, if the earnings of the business do not necessarily support the purchase price being paid by the purchaser, establishing the existence of personal goodwill may be easier as the excess payment suggests that the purchaser is paying for something beyond just the business assets.  Once the purchase and sale is consummated, the personal goodwill argument will be bolstered if the selling shareholder continues to render services for the purchasing corporation and is bound by a covenant not to compete and other restrictive covenants.

No one technique by itself can overcome the double tax consequences you may face when your corporation sells its assets.  Identifying your personal goodwill is one of the available tools for permitting you as a C corporation shareholder to minimize the burden of double taxation.  With proper planning and careful drafting by the legal team, a favorable tax result can be realized.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.