In a previous post, we noted that individual shareholders often seek to reduce the double income taxation (at both the corporate and shareholder levels) that accompanies a sale of assets by, and liquidation of, a C corporation by arguing that they own personal goodwill. By claiming goodwill as a business asset that is separate from the goodwill of the corporation, they thereby hope to avoid corporate level income tax on a sale of such goodwill.
Rarely, however, is the issue of personal versus corporate goodwill confronted in the context of the estate tax. That is not to say that personal goodwill is irrelevant in the valuation of an estate – far from it. Historically, appraisers and courts have considered the impact on the future earnings of a decedent’s business resulting from the loss of the “key man.” Specifically, if the earning capacity of the business will be substantially diminished due to the loss of the key employee (the decedent), an appropriate discount will be applied to reach the fair market value of the equity in the business.
The Tax Court recently considered a rather unique set of circumstances in determining the fair market value of a decedent’s business interests where the decedent was not the key man. In Estate of Adell v. Comr., the decedent’s gross estate included all of the equity in a C corporation. The decedent’s son served as president of the corporation, handled its day-to-day operations and, together with the decedent, served on its board of directors. The son never had an employment agreement or a non-compete with the corporation. Most of the corporation’s revenue was generated pursuant to a services agreement with a not-for-profit corporation, the sole employees of which were the decedent and his son. The not-for-profit’s primary source of revenue was from contracts that the son had secured in his capacity as a representative of the not-for-profit.
For purposes of the estate tax valuation of the C corporation, the estate’s appraiser valued the business as a going concern; he applied the “income approach,” which converts the anticipated economic benefits of a business into a present value. In doing so, he adjusted the corporation’s operating expenses to include a significant charge for the son’s personal goodwill. The appraisal report explained that the adjustment was appropriate because the success of the business depended heavily on the son’s personal goodwill. Moreover, the son did not have a non-compete with the corporation and as a result a potential buyer would acquire the business only to the extent that the business retained the son. This resulted in an increase in the projected operating expenses of the business and a decrease in its net cash-flow, which, in turn, reduced the valuation for the corporation.
The Court accepted the estate’s valuation. It recognized that a key employee may personally create and own goodwill independent of the corporate employer by developing client relationships. Though the employer may benefit from using the personally developed goodwill while the key employee works for the employer’s business, the employer does not own that goodwill and it is not considered an asset of the employer. The employee may, however, transfer his or her goodwill to the employer through an employment or non-compete agreement. Absent such an agreement, the value of the goodwill should not be attributed to the employer.
In the present case, if the son had quit, the corporation could not have exclusively used the relationships that he cultivated. Thus, the Court found that the appraiser properly adjusted the corporation’s operating expenses to include an economic charge at an amount great enough to account for the significant value of the son’s business relationships. In contrast, the Court said, the IRS not only failed to apply a charge for the son’s personal goodwill, but also gave too low an estimate of acceptable compensation for his services.
What does this holding mean for the valuation of other closely-held businesses? For estate tax purposes, the fair market value of a property is the price at which that property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or sell, and both having knowledge of the relevant facts. In the absence of an arm’s-length sale, the value of the business is determined by considering all relevant factors that would affect fair market value. These factors must be considered in light of the particular facts and circumstances of each case.
In the case of a family or other closely-held business, it is important to consider where the goodwill for the business resides: in the business, in the decedent, or in another employee? In the absence of an employment agreement or non-compete—not an uncommon situation, at least for owner-employees and their family members who are in the business—it may be possible to demonstrate that some portion of the goodwill does not belong to the business. This would seem to argue in favor a parent’s transitioning the business to his or her child and allowing the child to develop independent business relationships. However, this assumes a level of trust, especially in the absence of an employment agreement, with which the parent, and perhaps other members of the family, may not be comfortable.
While personal goodwill may be a good result from an estate tax perspective (unless the goodwill is the decedent’s), query the impact on the income taxes of the business and its owners. One must consider the loss of the basis step-up that the decedent’s property would otherwise enjoy if the goodwill were valued as part of the business, as well as the resulting amortization or depreciation deductions arising therefrom (in the case of an LLC or partnership with an IRC 754 election in effect), not to mention the reduced gain on a subsequent sale of the business. One must also consider whether the exclusion of “personal” goodwill from the value of the business may disqualify an estate from electing to make installment payments for that portion of the estate tax attributable to the closely held business.
Unfortunately, there is no “one-size-fits-all” answer, and taxpayers and their advisors will need to review all the relevant factors. Because proper planning may require the consideration of certain business factors and the making of certain business decisions (perhaps, for example, the execution of an employment agreement with a key employee), discussions should occur while the decedent is still alive. As always, the tax considerations should not overshadow the business and family consequences.