Very often, tax consequences determine how successful the sale of a business ultimately is. Owners often focus only on top line price, while structure and tax treatment can make a significant impact on how much of the purchase price the owner ultimately retains. Asset sales, while attractive to buyers because they allow for a “step up” in the basis of the assets up to the amount of the purchase price (enabling the buyer to take increased depreciation and amortization deductions), often create problems for owners. Because the seller in an asset sale is typically an entity, the sale proceeds have to pass into the entity and then out to the owners. This makes the sale proceeds subject to a double tax where the seller is a C corporation, an S corporation with earnings and profits, or an S corporation subject to the built in gains tax. In addition, certain state taxes, such as the Massachusetts “Sting Tax” may apply, further decreasing the net sale proceeds to the owners.
One potential option to reduce some of the tax bite is to arrange for a separate sale of the personal goodwill of the owner(s) as a part of the overall transaction. “Goodwill” is defined pursuant to Section 197 of the Internal Revenue Code as “the value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor.” Personal goodwill is an asset that belongs to the owner(s) of a business, not the business itself. It arises only where the owners take a direct and significant role in the operation of the business, where there are limited contractual relationships with customers and suppliers, and where their relationships, industry knowledge, reputation and expertise represent a significant portion of the value of the business. Put another way, if the business wouldn’t survive without the direct involvement of the owner(s), it is likely that there is a significant amount of personal goodwill built up. If a business would survive (or even improve) in the absence of an owner, then the goodwill is likely owned by the business itself.
In order to be separately sold, the personal goodwill must have a quantifiable value. It is advisable to engage an expert third party valuation firm to help value the personal goodwill, to help minimize the risk in the event of a challenge from a taxing authority. It is also helpful to try to highlight the value that the individual owner(s) add to the business, by carefully documenting things like industry awards won by the owner and letters from customers or suppliers highlighting the personal relationship.
If there is saleable, quantifiable personal goodwill, and the buyer is willing to structure the transaction to account for a separate purchase, the savings may be significant.
Since the individual and not the entity is the seller of the asset, the payments are made directly to the owner and the owner avoids the double tax hit. The amount payable to the entity is reduced, possibly reducing state taxes (and the impact of taxes like the Massachusetts Sting Tax). Lastly, personal goodwill is taxed at the capital gains rate, while some post-sale distributions to owners may be taxed at ordinary income rates, which are significantly higher.
Personal goodwill transactions can be complex, and there is risk to a party that tries to engage in one without careful planning and execution. In the right context, however, there are significant opportunities for tax savings. Business owners should consult with advisors very early in the transaction process to determine if there is such an opportunity, in order to maximize the chances for success.