In the acquisition of a closely held corporation, it is often important for the business buyers and sellers to allocate the total enterprise value between (1) the closely held company-owned entity goodwill and (2) the individual selling shareholder/employee’s personal goodwill.
This value/transaction price allocation has income tax implications both to the acquirer corporation and to the target company selling shareholder/employees.
Perhaps more important, this allocation may affect how the total business enterprise purchase price is allocated between (1) any nonemployee selling shareholders and (2) any employee selling shareholders.
This is because the nonemployee selling shareholders only receive their pro rata allocation of the target company stock value.
In addition to this pro rata sale price distribution, the selling employee/shareholders may also receive additional consideration as payment for personal goodwill.
In general, the sale of a closely held C corporation through an asset sale structure will result in two levels of income tax: (1) a taxable gain to the corporation itself, and (2) a taxable distribution to the selling shareholders.
One strategy for closely held corporation shareholders to avoid this double taxation involves the assertion that a portion of the business sale relates to the sale of the personal goodwill of the shareholder/employee.
This paper summarizes the analyst’s considerations with regard to the elements of, the separability of, and the documentation of a selling shareholder/employee’s personal goodwill and utilizes several key Tax Court decisions as illustration.
The primary requirement related to personal goodwill is for the business owner to establish that his or her personal goodwill exists separate from any closely held corporation’s entity goodwill.
Personal goodwill is property with a value dependent solely on the personal characteristics of the individual business owner.
A second requirement for the existence of personal goodwill is that the individual shareholder possess the right to sell his or her goodwill. And, the shareholder cannot have previously transferred that personal goodwill to the corporation.
Tax Court precedent establishes that personal goodwill is transferred to a corporation when the individual shareholder/employee cannot personally benefit from it without the employer corporation.
Certain formalities and documentation will help support the taxpayer positions taken with respect to personal goodwill. Personal goodwill should be valued by an independent valuation analyst, clearly identifiable in the purchase agreement, and agreed to by the acquirer.