When you first started your business, your attorney and CPA properly advised you that a corporation or a limited liability company (“LLC”) should be created to own and operate your pest control business. In this manner, the liabilities of the business (e.g., pesticide applications, customer property damage, employee injuries and employment claims, vehicular damage, etc.) can be shielded from your personal assets. However, although a corporation or LLC solves for the personal liability concerns, the type of legal entity formed has its own tax issues that can be unique in the context of a pending sale.
Small businesses are usually organized as either a corporation that elects to be taxed as an S-Corp or an LLC because both types are considered “pass-through” entities for federal income tax purposes. This means the entity does not pay a corporate level federal income tax but, instead, the annual net profits of the entity is reported on the owner’s individual income tax return. Conversely, C-Corp net profits are taxed at the corporate level at a flat 21% for federal income tax purposes and then, when distributed to the shareholders, is taxed a second time (as a dividend) at the shareholder’s personal level (i.e., the dreaded double tax).
So, what happens when you decide to sell your business and you now realize that being a C-Corp with a large taxable gain as a result of a sale will now attract a flat 21% federal tax? Having the owner sell the stock of the C-Corp is a solution to avoid the double tax but, in reality, is not a practical solution. The reason being that almost all purchasers want to structure the deal as an asset purchase. A stock deal is generally not desirable for a purchaser who wants to avoid inheriting unknown seller liabilities and also be able to get a tax write-off for the purchase price paid for the business. Even if persuaded to do a stock deal, any sophisticated buyer will likely discount the total purchase price offered due to the increased risks being assumed coupled with a loss of an expected tax deduction.
How about making an S-Corp election now prior to the sale? Unfortunately, making an S-Corp election will be ineffective because any asset sale within 5 years of making the election will be tainted and still taxed as if the entity was still a C-Corp — ergo the double tax will still apply. Waiting 5 years to avoid the double tax problem is impractical for a seller who needs/wants to sell in next 1-2 years.
How about taking additional salary and bonuses in the year of sale? This action will serve to reduce the corporate level tax (saving 21%) but creates another problem at the shareholder level. If a shareholder were to sell their stock the federal tax laws provide a reduced tax rate on long term capital gains at a maximum rate of 20% (plus another 3.8% if certain income levels are exceeded). Compare this to wages/bonus compensation (i.e., called “ordinary income”) that can get taxed as high as 37% at the federal level plus additional Medicare tax at another 2.9% (including the employer and employee portion given owner is the employer) given the compensation would be reported on IRS Form W-2.
So, what else can be done to minimize the C-Corp double tax and still obtain the benefits of the lower long term capital gain tax rate when a business is sold?
Tax Strategy – Sale of Personal Goodwill
Sellers faced with unacceptable alternatives have come up with a creative way to minimize the impact of the corporate level tax by separating personal goodwill of the seller’s owners from the business goodwill of the corporation itself. The acquisition of a selling shareholder’s personal goodwill is tax efficient because it provides the buyer with an amortizable asset while the selling shareholder only pays the lower personal long term capital gain tax on that allocated portion of the total transaction price that is no longer paid to the selling corporation but, instead, paid directly to the selling shareholder for the sale of their own personal goodwill. The two seminal cases that approved this approach in 1998 were Martin Ice Cream Co. v. Commissioner, 110 TC 189 (1998), and Norwalk v. Commissioner, 76 TCM 208 (1998).
First let’s understand what exactly “goodwill” is as a legally existing asset. A common resource defines goodwill as “an intangible asset category usually composed of elements such as name or franchise reputation, customer patronage, location, products, and similar factors.”
Personal goodwill exists because of the training and experience of the business owner who brings intangible qualities and personal ability/expertise which provide a reputation that customers recognize and therefore give loyal patronage in return. Conversely, business goodwill is more about brand name recognition of the company, efficient computer systems, trained employees, office location, business records and customer files, all of which create efficiencies for the company and its customers.
So, how does one differentiate Personal Goodwill vs. Business Goodwill if they seem to be intertwined? The partial listing of certain identifiable characteristics below highlight part of the analysis a taxpayer needs to undertake to make any conclusion whether the Martin Ice Cream case is helpful or not in establishing that a business owner has significant personal goodwill that is personally owned rather than a business asset of the C-Corp.
Personal Goodwill (Sample of Characteristics)
- More common in companies with higher portion of intangible assets
- No non-compete agreement exists between the selling shareholder and the corporation
- Business is dependent on owner’s personal relationships, reputation, skills, know-how
- Owner’s service is important to the sales process
- Owners are very involved with the business operations
- Companies that have short term contracts or terminable at will
- Loss of owner would negatively impact revenues/profits of the business
Business Goodwill (Sample of Characteristics)
- Existing Non-compete agreements
- A larger business with formal organizational structure, processes, and controls
- Sales are generated from company brand name recognition, company sales team
- Manufacturing businesses or companies that are asset intensive
- Selling shareholder is not intimately involved with the business
- Companies that have long-term contracts with customers
- Loss of owners would not materially impact revenues/profits
View of IRS Today and Recent Cases
The IRS scrutinizes these types of transactions and can and will be challenged and denied by the government if there is not proper documentation detailing the business appraisal and how important the selling shareholder is the corporation’s success. If the IRS determines that the personal goodwill was a last minute strategy to reduce the tax liability it will be denied.
Since 2008 there have been several cases were taxpayers unsuccessfully attempted to apply the Martin Ice Cream concepts but lost primarily because of lack of preparation and documentation. However, the Martin Ice Cream concept is still alive and a viable strategy as long as taxpayers take care to (i) get professional appraisal(s) that value the company assets as well as supports the personal goodwill allocation; (ii) properly document the strategy from the beginning and not be a simple after-thought; (iii) be careful the actual facts support the intended strategy in terms of distinguishing the types of characteristics; and (iv) be sure the seller does not have a non-compete agreement in place with the corporation.
Tax Strategy Conclusion
Although significant risk of challenge exists in adopting the sale of personal goodwill, case law is still in support of the technique as long as a taxpayer does their homework to stay away, if possible, from the mistakes and bad facts outlined in the recent cases where taxpayers were defeated.
This strategy can even be helpful in an S-Corp situation that is facing the 5 year waiting period following a conversion of a C-Corp. to an S-Corp. because the built-in gain tax imposed on the S-Corp can be reduced by the allocation and recognition of personal goodwill separate and apart from the appreciated assets of the S-Corp.
Finally, this strategy can be helpful in an S-Corp situation where certain states do not recognize the S-Corp election and, therefore, pay corporate level state taxes on an asset sale. For example, a $5M transaction where there is an 8% state corporate tax rate could draw a $400,000 state tax. Minimizing a tax bite like this is a worthwhile goal indeed.