There is a little-known asset – personal goodwill – that is present in certain types of businesses and can potentially provide a significant tax benefit when identified as part of a transaction. This article will clarify what personal goodwill is, the types of businesses that are likely to have personal goodwill, and its potential benefits in a transaction.
We first frame out the discussion by defining goodwill (overall, not just personal), as an intangible asset whose fair market value (FMV) is the difference between the FMV of a company, and the FMV of the sum of its tangible and identifiable intangible assets. In certain businesses, goodwill can be comprised of both corporate (also referred to as enterprise) goodwill and personal goodwill.
What is Personal Goodwill?
Personal goodwill is an asset that is specifically attributable to an individual rather than the company. The recognition of personal goodwill requires that at least a portion of the company's success or failure is dependent solely upon the professional(s) themselves, rather than that of the company. There are a number of key factors to consider in determining the presence of personal goodwill, including:
- The professional's reputation in the community for judgment, skill, and knowledge.
- The professional's experience, training, and ability.
- The professional's comparative professional success.
- The nature and duration of the professional's practice, either as a sole proprietor or a contributing member of a partnership or professional corporation.
- The business attributable to the professional is inseparable from the persona of the individual.
- The professional's demonstrated earning power.
- The professional's goodwill is not inheritable and assignable, sold, transferred, pledged, or conveyed.
- The age and health of the professional.
What Types of Business May Have Personal Goodwill?
A business started and operated by an individual is a common situation where personal goodwill is present given many of the key value drivers – customer relationships, know-how, reputation, etc. – were created by and associated with the individual rather than the company. Given the significant acquisition activity of physicians and related-type practices – and importantly the fact that they often have personal goodwill based on the nature of their operations – we utilize physician practices in our example for assessing the presence and benefits of recognizing personal goodwill during a transaction.
In the context of a physician's practice, one of the key questions is if an individual doctor or the overall practice is dictating the actions of a patient. To the extent that a patient seeks out a practice specifically for an individual doctor, rather than the company, the income generated by that patient is attributable to personal goodwill rather than corporate assets. Similarly, in situations where a referral source is referring patients to a specific physician, rather than the company, the referred patients, both current and future, would represent an asset of the physician (i.e., personal goodwill), and consequently would not represent a corporate asset owned by the company.
What are the Advantages of Recognizing Personal Goodwill in a Transaction?
In an acquisition of a C corporation (or an S corporation subject to built-in-gains tax) a purchaser is economically motivated to make an Internal Revenue Code (IRC) Section 338(h)(10) election to treat the transaction as a purchase of assets rather than stock. This election provides a tax benefit to the acquirer through a step-up in tax basis to FMV, rather than a carryover tax basis. This generates incremental future tax depreciation and tax amortization for the acquirer. However, this election can produce the opposite effect for a seller given they often have minimal or zero tax basis in assets (relative to having a tax basis in their stock), resulting in an increased capital gain and tax liability to the seller.
The increased tax liability for the seller under the IRC Section 338(h)(10) election is exacerbated by paying taxes at two levels; firstly, capital gains are calculated based upon the difference between the existing tax basis of the assets and the FMV of those assets (all at the corporate level); and secondly, the distribution of proceeds to shareholders from the company is taxed at the individual level. However, any consideration attributed to the acquisition of assets owned by the individual rather than corporate assets avoids this double taxation as it is taxed only once as a capital gain on the asset for the individual, typically at the long-term capital gains tax rate. In relation to the acquisition of personal goodwill, the acquirer is economically indifferent to the acquisition of personal or corporate assets, as they can amortize eligible intangible assets, including all forms of goodwill, pursuant to IRC Section 197.
Advantages of Recognizing Personal Goodwill in a Transaction – An Example
Consider a scenario in which an entity is purchasing an ophthalmology practice that greatly benefits from the exceptional reputation of a leading physician, with the following assumptions.
- Purchase price: $6.0 million
- Tangible assets: $1.2 million
- Corporate goodwill: $2.6 million
- Personal goodwill: $2.2 million
- IRC Section 338(h)(10) election
- Federal corporate tax rate of 21.0 percent
- Dividend tax rate on distributions of 20.0 percent
- Individual tax rate on personal goodwill of 20.0 percent
As shown in the following table the recognition of personal goodwill reduces the effective tax rate and increases the net proceeds to the shareholder:
| Without Personal Goodwill | With Personal Goodwill | |
|---|---|---|
| Purchase Consideration | $6,000,000 | $6,000,000 |
| Corporate Tax Liability (21% Federal) | 1,260,000 | 798,000 (($6.0mm - $2.2mm) x 21%) |
| After-Tax Proceeds | 4,740,000 | 3,002,000 (Corporate) |
| Tax on Personal Goodwill (20% Federal) | N/A | 440,000 ($2.2mm x 20%) |
| Dividend Distribution Tax (20% Federal) | 948,000 | 600,400 |
| Total Tax Liability | 2,208,000 | 1,838,400 |
| Net Proceeds to Shareholder | 3,792,000 | 4,161,600 |
| Effective Tax Rate | 36.80% | 30.64% |
Key Considerations
There are two vital points to consider in understanding whether an acquisition of personal goodwill is a viable approach to the structuring of the transaction:
- Personal goodwill cannot be transferable, thus the economic benefit of any activity restricted under the terms of an enforceable non-competition agreement cannot be captured when ascribing value to personal goodwill. If a physician has a non-competition agreement that completely restricts competition over a defined period, the physician's personal goodwill has essentially been transferred to the company. If the non-competition agreement has a geographic restriction i.e. the physician cannot practice within a five-mile radius of the company, revenue attributable to any current and future patients who would not follow the physician cannot be attributed to personal goodwill due to the non-competition restriction.
- The IRS could closely examine a transaction involving personal goodwill. We highly recommend having a detailed, narrative report providing qualitative and quantitative support for the personal goodwill valuation, prepared contemporaneously with the transaction negotiations.
Conclusion
Ultimately, attributing purchase consideration to the acquisition of personal goodwill can provide a significant benefit to the seller, while streamlining the negotiations between buyer and seller, which should be documented with a comprehensive valuation analysis to support a reasonable conclusion of value.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.