When a C corporation sells its assets, it recognizes gain equal to the excess of the amount realized on the sale (generally, the purchase price plus any liabilities assumed or taken subject to) over the adjusted basis of the assets being sold. This gain is subject to a corporate-level Federal income tax at a maximum rate of 35%. When the C corporation later distributes the remaining sale proceeds (after corporate tax) to its individual shareholders, in liquidation of the corporation, the shareholders also realize capital gain to the extent the amount distributed exceeds the adjusted basis for their shares of stock. Assuming the gain is long-term gain, it is subject to a shareholder-level Federal tax at a maximum rate of 20%, plus a potential 3.8% net investment income surtax, depending on the shareholder’s income level (both effective January 1, 2013).
Reducing the Double Tax
Taxpayers have long sought legitimate transaction structures by which they could reduce this double tax hit. In a recent decision, H&M Inc., T.C. Memo 2012-290, the taxpayer was successful in fending off an IRS challenge to one such structure. The taxpayer shareholder caused his C corporation to sell its biggest asset, an insurance-brokerage business, including the related customer lists and goodwill. (He kept the corporation alive to exploit certain patents.) The purchase agreement was contingent on the parties’ execution of an employment agreement. Under the terms of his employment agreement (which had a six-year term), the taxpayer received (i) a base wage, (ii) annual variable compensation based upon a percentage of net income, and (iii) deferred compensation.
Applying a substance over form analysis, the IRS asserted that the wages paid to the taxpayer under the employment agreement were actually payments to the C corporation for the sale of the insurance business, which should have been treated as capital gain and imputed interest income to the corporation. This reallocation, the IRS maintained, would account for the corporation’s goodwill and, so, would more accurately reflect the fair market value of the insurance assets at the time of sale. In support of this position, the IRS pointed to the fact that the taxpayer’s estate would still receive certain compensation payments if he died, the parties lacked documentation supporting their allocation, and the parties did not have adverse interests in the transaction because there were tax advantages for both of them in allocating more of the overall price to compensation.
The court disagreed with the IRS. It noted that “there will be no saleable goodwill . . . where the business of a corporation depends on the personal relationships of a key individual, . . . unless he transfers his goodwill to the corporation by entering into a covenant not to compete or other agreement so that his relationships become property of the corporation.”
The court went on to explain that the insurance business is “extremely personal” and the development of the corporation’s business before the sale was due to the taxpayer’s ability to form relationships with customers and with insurance companies. The court found that when customers come to the agency, “they come to buy from [the taxpayer] – it was his name and his reputation that brought them there.” The court also found that the taxpayer was required to perform extensive duties under the employment agreement.
The court concluded that the taxpayer and the buyer were genuinely interested in creating an employment relationship, and were not “just the massaging the paperwork” to achieve favorable tax consequences.
Planning for Personal Goodwill
So, what does this decision mean with respect to planning for future sales of assets by C corporations? Undoubtedly, many of you have come across the concept of “personal goodwill,” probably in the context of a sale by a corporation. As was mentioned above, taxpayers have sought to reduce the double taxation that follows an asset sale by a C corporation. Some shareholders have argued that they own personal goodwill, as a business asset that is separate from the goodwill of the corporation. They have then attempted to sell this “personal” asset to a buyer, hoping to realize capital gain in the process and also hoping to avoid corporate level tax on a sale of corporate goodwill (as the IRS suspected in the case above).
Of course, the burden is on the taxpayer to substantiate the existence of this personal goodwill and its value. The best chance of supporting its existence is in circumstances similar to those described above: a business where personal relationships are paramount, and where the shareholder is not a party to an employment agreement or a non-compete with the corporation the business assets of which are being sold. The fact that the shareholder has a unique set of skills, or that he developed a reputation and business relationships before forming the corporation is helpful. A specific reference to personal goodwill in a separate purchase and sale agreement is vital. The execution of a non-compete or consulting agreement between the shareholder and the buyer would further support the existence of the personal goodwill. Finally, a reasonable allocation of value between the personal goodwill, on the one hand, and the employment agreement, on the other, would likely help the arrangement withstand scrutiny by taxing authorities.
In summary, the existence of personal goodwill may, in the right circumstances, support a significant compensation package for a shareholder in the context of an asset sale by his corporation. It may also justify the sale of the goodwill itself as a separate, non-corporate asset. In each case, a separate, corporate-level tax would not be imposed in respect of this portion of the payments made to the shareholder. The circumstances in which either of these transaction structures may be employed, however, are fairly limited. Before a taxpayer jumps into them hell-bent on avoiding corporate-level tax, he needs to be certain that the existence and value of the personal goodwill can be substantiated. The taxpayer needs to plan well in advance.