Relationship Capital: How to Evaluate Personal Goodwill Prior to Selling a Closely-Held Business

By:
Ladidas Lumpkins, CPA, JD, LLM (Taxation) and Roman Katz, JD
Published Date:
Mar 1, 2018

How do you evaluate the financial power of relationships? An iconic scene from the movie The Devil Wears Prada offers great insight, particularly when powerful fashion editor Miranda Priestly recounts how she persuaded the magazine’s publisher to pass over a younger challenger for the job:

“Truth is, there’s no one that can do what I do. Including her. Any of the other choices would have found that job impossible, and the magazine would have suffered. Especially because of the list. The list of designers, photographers, editors, writers, models—all of whom were found by me, nurtured by me, and have promised me will follow me whenever and if ever I choose to leave Runway. So, he reconsidered.”

In essence, “the list” represents a tangible example of “personal goodwill,” an accounting concept where the value of an individual’s relationships, reputation, or standing with customers stands apart from separately identifiable “corporate goodwill” assets—such as the firm’s brand name, patents, or proprietary technologies, which are clearly owned and valued as part of the business.

Why does the distinction matter? The distinction becomes important whenever one has to value a closely held business for estate or income tax purposes. In the event a business is sold, the amount apportioned to personal goodwill is considered a long-term capital gain and taxed at a maximum of 20% (plus 3.8% net investment income tax for single earners with adjusted gross income above $200,000). If careful evaluation and planning steps are not taken before the start of a prospective sale, personal goodwill in a C corporation entity (even if established by virtue of a non-compete agreement or other facts developed after the fact) will typically be taxed at the prevailing corporate rate when the transaction closes—and again at the capital gains rate when profits are distributed as dividends to shareholders. The double-tax hit on the latter means less money in owner and shareholder pockets after a sale. The existence of personal goodwill can also impact the value of a company for gift and estate tax purposes.

This article will discuss some of the case law that has shaped current definitions and regulatory views of this valuable estate and tax planning tool, as well as important steps companies can take to develop facts supporting the existence of personal goodwill well before a prospective sale.

A Big Scoop of Personal Goodwill, A Smaller Tax Bite

Most tax experts generally agree that the Martin Ice Cream Co. v. Commissioner stands as the landmark case that solidified personal goodwill as a recognized accounting and tax-planning concept. Martin Ice Cream Co. was a small company that distributed products to supermarket chains, independent grocery stores, and other food service accounts. In 1974, the controlling shareholder of Martin Ice Cream (Arnold Strassberg) entered into an oral agreement with the founder of Häagen-Dazs, allowing Strassberg to handle supermarket distribution of that brand of ice cream products. More than a decade later, when Häagen-Dazs was in the process of being acquired by The Pillsbury Co., those distribution rights and goodwill were negotiated and included as part of the transaction. When the deal closed, Martin Ice Cream was taxed on both the sale and resulting dividends.

In a post-sale challenge to the IRS, the U.S. Tax Court observed that Arnold Strassberg “built the business of wholesale distribution of super-premium ice cream to supermarkets on the foundations of his personal relationships with the supermarket owners,” adding that his personal position in the market “retained considerable value” at the time Pillsbury completed its acquisition of Häagen-Dazs.

Practical takeaway: The value of Martin Ice Cream’s business relationships and distributor rights largely stemmed from Arnold Strassberg’s “personal goodwill” with these entities. Because, however, Arnold Martin did not have a formal employment agreement with Martin Ice Cream, he retained full ownership of his personal goodwill. Thus, those intangible assets were never owned by Martin Ice Cream and could not be conveyed as part of the overall transaction. That reduced the tax liability on the sale.

Who’s More Valuable—the Company or a Key Employee? 

The sale of a company is not the only time when personal goodwill may come into play. In fact, this intangible asset also can have important considerations in estate valuation and taxation.  

Consider the case of Franklin and Kevin Adell, the owner and president, respectively, of STN.Com. This technology company provided exclusive uplink broadcast services to The Word, a religious nonprofit television station launched by the Adell family. In a services agreement between the two entities, The Word agreed to pay STN.Com at least 95% of its revenue each month, which covered operating expenses for the station and various personal expenses for Franklin Adell, Kevin Adell, and other family members.

After Franklin Adell died in 2006, Kevin Adell was appointed trustee and estate representative. When the first estate tax return was filed with the IRS, the date-of-death value of STN.Com was recorded as $9.3 million; however, after a pair of amended returns, the estate in 2010 claimed the value of STN.Com was zero, which prompted a notice of estate tax deficiency from the IRS. After rounds of valuations followed, the parties went to U.S. Tax Court, with the estate claiming a revised date-of-death value for STN.Com at $4.3 million and the IRS claiming fair market value at just over $26 million.

Practical takeaway: Kevin Adell was clearly the key employee in this media organization. To build a base of content for The Word, he personally negotiated contracts with a number of faith leaders and their affiliate organizations. In fact, the Tax Court later noted that “the ministers conducted business with Kevin because they trusted him personally, not because he was a representative or an employee of STN.Com.” Because Kevin Adell did not have a non-compete agreement or other employment contract, however, his personal goodwill could not be directly tied to STN.Com. For those reasons, the Tax Court reduced the fair market value of STN.Com’s stock from $26 million to the initial valuation of $9.3 million, because it “properly accounted for Kevin’s personal goodwill and appropriately used the discounted cash flow analysis of the income approach to value the STN.Com stock.”

 The Gift of Personal Goodwill? Not So Fast.

Another recent case highlighting the value of personal goodwill involves Chester Bross, who owned several road construction enterprises in the Midwest. One of those companies was Bross Trucking, which he launched in 1982 as a hauler to transport materials for his road construction projects.

After a series of safety related violations threatened to shut down their father’s trucking business, the three sons of Chester Bross decided to launch LWK Trucking, a new and separate entity from Bross Trucking. This business was largely funded by the three Bross sons, who held 98% of Class A shares in the new entity. Chester Bross was not officially involved in the launch or operations of LWK Trucking, and the new trucking company took on different lines of business than those traditionally serviced by Bross Trucking. On the other hand, LWK Trucking did make use of many fleet vehicles from Bross Trucking (in many cases, using magnetic signs to hide the Bross logo with the LWK name) and employed a number of workers who had previously worked for Bross Trucking.  

When Bross Trucking vs. Commissioner came before the U.S. Tax Court in 2014, the IRS alleged a series of income and gift tax deficiencies totaling over $2 million. The primary issue was whether Bross Trucking had distributed intangible assets to Chester Bross, and whether such appreciated intangible assets had been gifted to his three sons. In its opinion, the court noted that at the time in question, Bross Trucking’s regulatory and safety issues were the “antithesis of goodwill,” later adding, “LWK Trucking was trying to hide any relationship with Bross Trucking because association with the targeted company was seen in a negative light.”

Practical takeaway: Due to his decades of accumulated business relationships and industry knowledge, the Tax Court noted that Chester Bross possessed a sizable reservoir of personal goodwill. Because he had no employment contract or non-compete agreement with Bross Trucking, the court held that his personal goodwill was not owned by that company, meaning that Chester Bross and his wife could not be liable for income or gift taxes on intangible assets that were never distributed.

Critical Issues to Support the Existence of Personal Goodwill 

Here are four quick touchpoints to help navigate and document personal goodwill in your organization:

Personal goodwill relies on facts and circumstances. Ultimately, the IRS places the burden of proof on the taxpayer to demonstrate specific facts and business circumstances that validate separation of personal goodwill from corporate goodwill. These issues were clearly illustrated in both the Martin Ice Cream and Adell cases, where the value of personal relationships was far more important than the demonstrable value of actual business entities without those individuals. Thus, it’s wise to review how the existence of personal goodwill (if any) may contribute to a company’s customer loyalty, market position, and overall growth.

Personal goodwill can be enhanced—or eliminated—by non-compete and employment agreements. If evidence suggests that an owner or employee’s personal goodwill has substantially contributed to business success, it’s wise to approach that individual and negotiate mutually favorable terms for an employment or non-compete agreement. 

The timing of such agreements is critical, particularly from a succession planning or future sale viewpoint. If an employment or non-compete deal has been executed prior to when a company goes up for acquisition or sale, the deal strengthens the legal argument that “personal goodwill” exists as an asset the individual has the right to sell. To successfully complete a sale of personal goodwill, that goodwill must be separable from the goodwill of the corporation and must not have been transferred previously by the employee. For instance, in a sale of a closely held corporation, the business sale transaction needs to have the following split structure: 1) the sale of a closely held corporation and 2) the sale of the employee’s personal goodwill.  

Personal goodwill can be bolstered by independent appraisals. In the Adell case outlined above, the presence of an independent appraisal discounted the value of STN.Com due to Kevin Adell’s personal goodwill. That documentation helped him ultimately prevail in his Tax Court challenge against the IRS.

Personal goodwill relies on fair, accurate documentation: Both the Martin Ice Cream and Adell cases were solid examples of “substance over form,” meaning that any consideration of—or payments for—personal goodwill should reflect the economic reality of a given deal, largely by measuring the value of that goodwill in relation to other valuable assets in a transaction.

A case that failed this test was Kennedy v. Commissioner. James Kennedy sold his consulting business to a larger firm (Mack & Parker) in a deal where 25% of the purchase price was considered payments for ongoing consulting and 75% as payment for Kennedy’s personal goodwill with customers. While the Tax Court agreed that Kennedy retained personal goodwill, it also said that the lack of a third-party appraisal raised questions about the legitimacy of the deal’s payment allocation percentages:

“Even though a payment to a service provider can be considered a payment for goodwill in certain circumstances, we are convinced that the payments to Kennedy were consideration for services rather than goodwill. We find it significant that there is a lack of economic reality to the contractual allocation of the payments to goodwill. In other cases, the contractual allocation of a portion of a payment to goodwill has been important in determining that the payment was indeed for goodwill. In those other cases, the contractual allocation appeared to genuinely reflect the relative value of the seller’s customer relationships compared to the value of the seller’s ongoing personal services. Here, however, the allocation of 75 percent of the total consideration paid by Mack & Parker to goodwill was a tax-motivated afterthought that occurred late in the negotiations.”

As Miranda Priestly reminds us, personal goodwill can be a powerful asset. That said, early evaluation and documentation of such assets is critical, and employment or non-compete agreements that are completed before a company goes on the market help to establish that two different sales are taking place—and therefore two different tax treatments should be applied. 


Ladidas Lumpkins, CPA, JD, LLM (Taxation), is partner of the trust & estates department of Prager Metis CPAs, LLC, a member of Prager Metis International LLC. She has been working in the industry for over 15 years, providing domestic and cross-border strategic tax planning, compliance and consulting to high-net-worth families and their closely held businesses.

Roman Katz, JD, is an associate of the trust & estates department of Prager Metis CPAs, LLC, a member of Prager Metis International LLC. He specializes in gift, estate, and income tax compliance and consulting.

 
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