(taken from the July/August 2006 issue of On Balance magazine)

Case Study:

Using Personal Goodwill to Reduce Taxes

By Daniel B. Geraghty, CPA, JD

Since 1986, the repeal of General Utilities has frustrated taxpayers and tax practitioners alike. While a clear and legal way around the repeal may be the holy grail of tax planning, there are certain situations where the repeal may, upon closer examination, not even be relevant.

One such situation is where the shareholder of a corporation owns valuable rights separate from the corporation, in many cases, personal goodwill. While the cases establishing the concept of "personal assets" have been around for some time, a review of their application and limitations is useful for identifying situations where a tax adviser can save a client significant taxes.

The case that caught most practitioners’ eyes in this area is Martin Ice Cream v. Commissioner, 110 T.C. 189 (1998). In Martin Ice Cream, a father and son operated an ice cream distributorship. The son focused on a certain business segment, whereas the father eventually focused on distributing premium brand ice cream (Haagen-Dazs) to large supermarkets. The father personally developed relationships with both Haagen-Dazs and the purchasers in the industry. The oral agreement for the distribution rights to Haagen-Dazs was between the father and Haagen-Dazs.

These relationships were nurtured over the span of several decades. The father was a well-connected and respected player in the budding market of high-quality ice cream products. The father and son eventually had a disagreement over the business and agreed to part ways.

The company split off the father’s line of business to the father by contributing the assets of the premium brand division to a new company and distributing this stock to the father in exchange for his shares in the company, intending the transaction to qualify under Code Section 355 a tax-free spinoff.

The IRS disagreed and contended that the spinoff triggered a gain to the company under Code Section 311 equal to the amount of the goodwill associated with the premium brand division. To the contrary, the taxpayer argued that he had personally worked to develop the relationships that were key to the business and that without him, the business would have little or no value. The assets were always his and never could be distributed from the company. Significantly, and critically, the company and the father had neither an employment agreement nor a non-compete.

The Tax Court agreed with the taxpayer, finding that the goodwill was associated with his relationships and never was an asset of the company. The father had developed the relationships and goodwill and was free to take them with him when he left the company. He merely made them available to the company. As the court noted, "Those personal assets are entirely distinct from the intangible corporate asset of corporate goodwill." Haagen-Dazs, supra at 207 (citations omitted).

In a case decided the same year as Martin Ice Cream, the Tax Court ruled in a similar fashion in Norwalk v. The Commissioner, 76 T.C.M. (CCH) 208 (1998). This case involved liquidation of an accounting practice of two individual accountants. Given the personal nature of the services provided to the clients and the relationships of the accountants with the clients, the Tax Court found the goodwill to be the personal asset of each accountant, which did not trigger gain on the liquidation of the corporate accounting practice.

While there were originally employment agreements with the employees, these had expired by the time of the liquidation. Again, the Tax Court focused on the importance of the personal goodwill, in this case the nature of the personal services as well as the personal relationships of the accountants with their clients.

As with Martin, the lack of a non-compete was a critical fact in finding for the taxpayer.

For the tax adviser, the lesson of these two cases is that in the sale of a business held by a C Corporation, the sale of personal assets, such as a personal goodwill, must be considered. Whether the Martin Ice Cream and/or Norwalk cases are helpful to the particular taxpayer depends on the specific facts and circumstances surrounding their situation.

Where the owner/operator is critical to the success of the business because of relationships, personal skills or other rights associated with the owner (say, for example, a certain contractual right such as a franchise that is personal to the owner), a payment outside of the corporation for the personal asset can be a valuable planning tool.

Tax advisers will need to exercise care in looking at the facts as well as any relevant documentation such as a non-compete or employment agreement. While personal goodwill is normally associated with professional service corporations owned by accountants, lawyers, doctors and the like, Martin Ice Cream demonstrates that personal goodwill exists in other situations, as well.

What is important is that the taxpayer has worked to develop and exploit his personal skills or relationships and that they own these assets individually. When these facts exist, while not quite the holy grail of tax planning, the concept of personal goodwill or personal assets can be a powerful planning tool.

Daniel B. Geraghty, CPA, JD is an attorney at Godfrey & Kahn SC in Milwaukee. He can be reached at dgeraghty@gklaw.com or (414) 287-9237.

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