In the Brueggeman and Johnson Yeanoplos May/June 2015 Litigation & Valuation Report, one of the articles is titled, “Determining the Value of Personal Goodwill.” Let’s discuss how it applies to small and mid-size business buy-sell.
First lets define goodwill in general. Goodwill is the difference between the total value of the company and the value of the tangible assets. Technically, it’s the value of the business’s name, intellectual property, reputation, etc. in real life it’s the value of the business based on its profits (after owner salary) above the value of the tangible assets. It is not “blue sky,” which is a value attributed to future, and might-never-happen, profits.
Company goodwill is based on what the company has. It could be a product, culture, service, management team, or many other things.
Personal goodwill is the value attributed to the owner’s involvement with the business. In other words, if there’s a lot of personal goodwill, there’s a huge dependency on the owner, which could bring the value of the business down (versus a business with no personal, all company, goodwill).
Personal goodwill can come into play in a handful of areas including:
- Divorce litigation (the non-active spouse’s share may be worth less).
- Shareholder agreements (again, the owner creating the dependency may have shares worth more).
- Buy-sell deals.
In buy-sell deals this issue is raised when the company being sold is a C corporation (vs. an S corporation or LLC with flow-through tax structures). To avoid double taxation (tax on the corporation and again on the shareholders), if the business qualifies, there are ways around the double taxation problem.
There are strategies like IRS code 338(h)(10) and IRS code 336(e), but for smaller businesses, there is also the strategy of buying personal goodwill directly from the seller, not from the company. I say for smaller companies because the larger the business, the less chance of a dependency on the owner, aka personal goodwill.
The precedent for this is a court case, IRS vs. Martin Ice Cream. My layman’s explanation is the court decided it was acceptable for a buyer to purchase the stock or assets of a (C) corporation, usually up to basis or just beyond, from the company, and to purchase personal goodwill directly from the owner/seller. By doing this, the seller pays capital gains taxes on the goodwill, not double taxation as it’s taxed at the corporate and personal levels.
I’ve had about a dozen clients use this technique over the years and the key is being able to prove the seller actually has created personal goodwill. Is he instrumental to the sales process with all the top client contacts? Is she the only one who is able to finalize project bids? Or, are there any other dependencies we can attribute to the seller?
Of course there’s a flip side, a real dependency on the seller is not always good news to the buyer. It means there’s a bottleneck if those skills leave.
Legitimacy: From the B&JY report, “Bross Trucking [the court case they mentioned] confirms that personal goodwill is a viable asset, distinct from business goodwill. It can be transferred… separately from business goodwill, depending on the facts and circumstances.” Given the massive amount of tax code we have in this country, it’s not surprising there’s a myriad of techniques to, legally, get around some of the codes.