With financial conditions tightening and a tidal wave of baby boomers reaching retirement age, many of your clients may be thinking about selling their businesses. As I discussed last month, when owners sell their companies, especially their professional service firms or companies they built from the ground up, they have an important, but often misunderstood asset called “goodwill.” That’s the amount a buyer pays them above and beyond the value of the business’s hard assets and liabilities. On the surface, we’re talking about the entire value of the business’s intangible assets, but for tax purposes and valuation purposes, it’s worth looking closer at those intangible assets.
Last month’s column generated a number of questions about goodwill from WealthManagement.com readers, so I’ll answer them below:
Main Components
Q: What are the main components of goodwill, and how should I value them?
A: It’s important to help your client distinguish between “corporate goodwill” and “personal goodwill.” Corporate goodwill includes existing arrangements with suppliers, customers and strategic partners. Personal goodwill is based on the continued presence of a particular individual and may be attributed to the individual’s personal skill, training, relationships, use of the individual’s name in the business name and the individual’s longtime name recognition in a geographic area or industry.
Tax Implications
Q: What are the tax implications regarding goodwill?
A: In general, the sale of goodwill is taxed at the capital gains rate, not the ordinary income rate. Further, buyers typically prefer asset sales over stock sales due to step-up in basis, liability issues, etc. Also, buyers can amortize purchases of goodwill under Internal Revenue Code Section 197.
Importance of Personal Goodwill
Q: Why is personal goodwill so important?
A: For C corporation asset sales, personal goodwill sales aren’t subject to double taxation as they are with corporate goodwill sales. Also, for S corporation asset sales, personal goodwill proceeds can be allocated differently than the pro rata distribution of business asset proceeds. In addition, there’s no business entity level gain on the sale of personal goodwill. Finally, personal goodwill gives your client and their advisors several opportunities to do individual-level tax planning with a discrete asset transaction. =
Determining Whether Personal Goodwill Exists
Q: How do I know if my client’s goodwill is really personal?
A: First, be sure there are no non-compete agreements between the owner and the business. Once that hurdle is cleared, make sure you can document that your client’s business depends heavily on their personal relationships, industry reputation, skills, know-how, etc. Also confirm that your client is highly involved in day-to-day operations and that their ongoing service and contribution to the business is critical for a successful ownership transition. It also helps if your client’s business is in a regulated, highly technical or specialized industry (that is, professional services) and that business contracts are terminable at will or tied to the owner. Finally, personal goodwill is clearly defendable to the Internal Revenue Service if the owner’s departure will have an adverse impact on the business.
Intangibles
Q: How do I know if certain intangibles are company goodwill, not personal goodwill?
A: I get this question often from founders and their advisors. It’s considered company goodwill if the business can continue running fine after the founder/owner walks away or takes a very long vacation. Here are some other things to look for when it comes to company goodwill:
- There are non-compete agreements in place that effectively prevent the owner from competing with the business after selling;
- There are agreements that convert all “intangible” efforts to a “work for hire” status;
- The business is highly systemized, with well-documented organizational structures, processes and controls;
- The company generates more revenue from the business brand name and sales team than it does from the founder/owner;
- The business has a diversified customer roster and revenue base;
- The founder/owner is “passive” in day-to-day operations and/or the business has a strong management team (separate from the owner); and
- Business contracts aren’t tied to an individual owner.
Valuing Personal Goodwill
Q: What’s is the best way to value personal goodwill fairly?
A: There are myriad factors that go into valuing personal goodwill. A good starting point is to look at the age and health of the owner as well as the owner’s earning power within the business, the strength of the owner’s vendor and customer relationships and the owner’s reputation in the industry and local area. It’s also good to look at how long the owner has been involved with the business and the owner’s relative success compared to their industry peers.
The four methods for valuing personal goodwill are:
1. With and without method. Compare the company's value with the owner still working at the business, to the projected valuation after the owner leaves. The difference is the goodwill;
2. Top-down method. The residual of purchase price allocation);
3. Bottom-up method. Business assets vs. personal assets); and
4. Excess earnings/compensation analysis. The capitalized amount of the owner’s actual earning capacity over fair market value of compensation of an individual with similar skills).
To determine the best approach and methodology for your client’s particular situation, hire a qualified business appraiser who can value personal goodwill based on industry standards and other comparable metrics.
IRS Challenge
Q: What should we do if the IRS challenges our goodwill amount?
A: In the IRS world, taxpayers are guilty until proven innocent. The IRS assumes the goodwill gain occurred at the business entity level and then distributions were made by the business entity to the owner, subject to all tax effects. However, the burden of proof shifts back to the IRS if your client can present credible evidence to the contrary. Again, that’s why it’s so important to obtain an independent valuation from a qualified appraiser and not just rely on “stated value.”
Best Possible Deal
Q: What steps can I take to help my client get the best possible deal after taxes and transaction costs?
A: As I discussed last month, make sure you and your client take the time to get your ducks in a row. Don’t rush to meet an arbitrary deadline even if that’s what your bankers and attorneys are pushing for. Also:
- Carefully document the importance and history of the owner’s personal relationships. If nothing else, make sure they don’t create something that’s not there. If the owner didn’t create the key customer relationships, don’t imply that they did. If they were instead the developer of the unique and successful business process, focus on those. Of course, if the seller is a physician and the medical practice is being sold, the seller’s medical skills and personal reputation should be the focus.
- Make sure your client carefully structures their pre-sale corporate documents, that is, shareholder, confidentiality and employment contracts and “founder’s rights” clauses. Also, disclose your client’s intent to allocate a portion of the total purchase price to personal goodwill as early in the negotiations as possible with the buyer. If possible, include that intent in the initial Letter of Intent. Personal goodwill shouldn’t be a “tax afterthought.”
- Pay attention to deal structure documents. Either have a separate personal goodwill sale agreement or identify the goodwill as a separate asset sale in the asset purchase agreement. Make sure to enter into a non-compete agreement between the individual owner and the buyer. If the individual owner is continuing with the business, make sure they enter into an employment agreement with the buyer (that is, convert personal goodwill to enterprise goodwill for the buyer’s benefit).
It's also important to spend time on the purchase price allocation. Consider these three important issues:
- Inventory the personal assets separately from the business assets;
- Value the personal goodwill separately from the company goodwill and other business assets; and
- Agree to a personal goodwill value and purchase price allocation schedule in advance of the closing.
Follow the Money
Finally, follow the money. Make sure the economic substance of your client’s transaction matches the tax impact. Having your clients maximize the value of what they net from a sale adds tremendous value to any sales transaction.
Randy A. Fox, CFP, AEP is the founder of Two Hawks Consulting LLC. He is a nationally known wealth strategist, philanthropic estate planner, educator and speaker.
