Typically the sale of a corporation through an asset sale will result in two levels of tax when dealing with a C Corporation. There is likely to be taxable gain to the corporation, and a taxable distribution to the shareholders of the corporation. Hence, the term “double taxation” that has been used to describe the corporation paying income tax and shareholders being taxed on the distributions. There is a potential strategy that shareholders of a corporation (likely a closely held corporation) can use to avoid this double taxation. This strategy would involve the shareholder taking the position that a portion of the price paid (the purchase price) is for personal goodwill. Because this portion being paid is for personal goodwill, it should be taxed as capital gain to the shareholder. Thus, the amount allocated as personal goodwill is not taxed as corporate income, and receives capital gain treatment. This sounds too good to be true, and in many instances it may be, or can be reviewed, scrutinized and challenged by the IRS. Thus, it is very important that the shareholder(s) consult with their tax attorney, business attorney and/or another tax professional prior allocating a portion of the purchase price as personal goodwill. The article below has been prepared by a tax attorney in Denver at The McGuire Law Firm to provide additional information regarding personal goodwill.
The idea or concept of personal goodwill is based upon the notion that a certain portion of the businesses success can be attributed to an individual or individuals. For example, perhaps the individual shareholder has wonderful relationships with clients, and thus a good deal of the businesses success may depend on this individual. Further, the relevant court cases display that covenants not to compete and the asset purchase agreements play important roles in determining personal goodwill. In general, the more recent cases have held that if a taxpayer (shareholder) enters into some form of employment agreement or a covenant not to compete with the corporation, the personal goodwill would likely be transferred to the corporation, and thus a corporate asset as opposed to an asset of the taxpayer (shareholder). Furthermore, it is very important that the parties properly document the personal goodwill in the negotiations and the asset purchase agreement. The court is likely to review the communications between the parties and the purchase agreement to check for the existence of the personal goodwill, which likely would or should be discussed and included within the agreement if in fact a portion of the purchase price is being allocated to personal goodwill. In addition to reviewing the related documents to the transaction, it may be wise to obtain a third part valuation to establish the personal goodwill and value of such personal goodwill.
The above article has been written by John McGuire, a tax and business attorney in Denver, Colorado and the founding partner of The McGuire Law Firm. You can contact Mr. McGuire at 720-833-7705 or John@jmtaxlaw.com.