Allocating value to personal goodwill can materially affect the tax consequences of a business sale, estate valuation, or gift transfer. But the planning only works when the facts support that the goodwill truly belongs to an individual rather than the business entity. In any business enterprise, goodwill can be a significant and valuable asset. Goodwill is defined as “a business’s reputation, patronage, and other intangible assets that are considered when appraising the business, esp. for purchase; the ability to earn income in excess of the income that would be expected from the business viewed as a mere collection of assets.”[1] The question often becomes, however, who owns that goodwill – the business entity or an individual associated with the business. To the extent business success relies on the personal relationships, expertise, or reputation of a key individual who has not transferred those personal assets to the business through an employment agreement, non-competition agreement, or otherwise, those intangible assets belong to the individual.[2]
The owner of goodwill associated with a business can have significant tax consequences. In the sale of assets of a C corporation, a post-sale liquidation of the corporation triggers two levels of tax – one at the corporate level on the corporation’s sale of assets and another at the shareholder level on liquidation of the corporation. However, when an individual shareholder sells his or her personal goodwill, that is subjected to only one level of tax applicable to that shareholder. Additionally, the tax rate that applies should be at capital gains rates at a top federal income tax rate of 20%. For sales of corporate stock, C corporations or S corporations, the buyer gets no tax benefit through amortization of their purchase price. Rather, the buyer merely obtains cost basis in the purchased stock. On the other hand, to the extent the stock sale transaction can include a shareholder’s sale of personal goodwill, the buyer is permitted a 15-year straight-line amortization.[3]
In the estate planning context, estate tax is based on the value of assets held at death. If a significant value of an operating business is allocable to a key employee’s personal goodwill, then that should reduce the value included in a deceased owner’s taxable estate. Likewise, when gifts are made of business interests, often to junior generations in a family, to the extent the donee of those gifts holds significant personal goodwill, the value of the gift should be reduced. That said, for non-taxable estates (under the current $15 million per person estate tax exemption less prior exemption used), reduction in the value of a business minimizes the cost basis adjustment, i.e. potential step-up in cost basis, available at death.[4] As such, depending on the circumstances, allocation to personal goodwill in the estate planning context can be a double-edged sword.
The IRS often resists personal goodwill allocations arguing that the customer relationships, going-concern value, and other intangible value were developed within the business and therefore belong to the entity. The IRS also may argue that value attributed to personal goodwill is really disguised sale consideration, a constructive dividend, or an undervaluation of transferred business interests.
Recent Cases
In analyzing the applicability of personal goodwill to planning contexts, a few more recent Tax Court cases are worth reviewing. Although at least a couple of those opinions may not be terribly “recent,” they are some of the most recent cases addressing this issue.
Bross Trucking[5]
In the Bross Trucking case, the IRS argued that a father received a taxable dividend of goodwill value from a corporation that he then gifted to his sons. This ultimately could have triggered two tax issues – income tax and gift tax.
The relevant business was in the trucking industry and had faced regulatory and safety problems. To avoid a cease-and-desist order that would have halted operations, the owner began working for a new business formed by his three sons. That owner, Chester, had significant contacts in the trucking industry. As such, the IRS argued that diversion of the business from his wholly-owned corporation to the new business established by his sons constituted a dividend from his corporation and gift to his sons. However, the Tax Court noted that Chester has not transferred his personal goodwill to the corporation through any employment agreement, non-compete, or otherwise. Further, given the regulatory and safety issues the historic business was facing, the court effectively found there to be “badwill” as opposed to goodwill.
Ultimately, this was a taxpayer victory finding that no corporate goodwill was distributed to Chester in a taxable transaction and that Chester did not transfer any such goodwill to his sons for gift tax purposes. A significant underpinning of this outcome, aside from the negative goodwill or “badwill” that may have existed, is that Chester was never under any non-competition or other agreement assigning his personal goodwill to anyone other than himself. He was free to use that goodwill as he chose.
Adell[6]
Here, the IRS assessed estate tax based on their position that the decedent’s estate undervalued his ownership interests in the family business STN.Com, Inc. At issue was the value of the personal goodwill of the decedent’s son, Kevin. It seemed clear that Kevin was the face of the business and held most of the primary business relationships that brought revenue to the corporation. Kevin never signed a non-competition agreement, employment agreement, or other contract that limited his ability to compete with the family business or use those personal relationships for himself or another employer.
The Tax Court agreed with the taxpayer that the value of the family business in the taxable estate of Kevin’s father needed to be offset with the value of Kevin’s personal goodwill. In this case, that ended up being approximately 40% of the overall enterprise value. This was supported by expert valuation reports.
Huffman[7]
In this more recent case, Lloyd and Patricia Huffman initially acquired ownership in Dukes (later Infinity Aerospace, Inc., but referred to here and by the court as Dukes), an S corporation. Their son, Chet, worked for that family business. As an employee of the family business, Chet developed important relationships with key employees and customers. At no point did Chet transfer his personal goodwill to the business through an employment agreement, non-competition agreement, or otherwise.
The family sold Dukes and allocated a significant portion of the purchase price to Chet’s personal goodwill for which he was directly compensated. The IRS argued that all goodwill belonged to Dukes and should be allocated accordingly. The Tax Court, however, noted similar factors to the other cases discussed in this writing. Chet had valuable business relationships and had the freedom to use those relationships with Dukes or elsewhere. When Dukes was sold, substantiating his personal goodwill value, an independent valuation of Chet’s personal goodwill was obtained (finding $21.8 million of the $50.042 million purchase price to be attributable to Chet’s personal goodwill), the transaction documents reflected Chet as the owner of personal goodwill, and Chet was bound by a post-closing non-competition agreement (i.e. he gave up his freedom to use that goodwill against the buyer). Based on these facts, the court agreed with the taxpayers that Chet was the owner of his personal goodwill, even if at a slightly lower value than reported. This was a significant taxpayer victory.
Conclusion
The concept of personal goodwill in tax transactions and tax planning can be important. This can have income tax implications as well as estate and gift tax implications. In advising businesses, especially family businesses, tax planners need to recognize the impact personal goodwill can have. This is both being defensive to avoiding IRS attacks on intended tax outcomes and offensive to structure affairs in a tax favorable manner. Proper planning and understanding the effect of personal goodwill can provide valuable results.
In evaluating planning with personal goodwill, the cases cited in this writing provide important context. Due diligence is necessary to determine whether personal goodwill has been assigned to the operating business, contemporaneous valuations should be considered to substantiate the value of personal goodwill, and legal documents should reflect the effect of personal goodwill on business transactions. It is clear that the IRS does not like taxpayers aggressively allocating to personal goodwill. In many cases, the IRS will assert income, gift, estate, and other tax deficiencies. However, when due diligence substantiates individual ownership of business goodwill, independent valuations support the value of that goodwill, and relevant legal documents are consistent with that allocation, courts have been supporting taxpayers.
[1] Black’s Law Dictionary (12th ed. 2024).
[2] See, e.g., Martin Ice Cream Co. v. Commissioner, 96 T.C. 189 (1998).
[3] IRC § 197.
[4] IRC § 1014.
[5] Bross Trucking, et al. v. Commissioner, TC Memo 2014-107.
[6] Estate of Adell v. Commissioner, TC Memo 2014-155.
[7] Huffman v. Commissioner, TC Memo 2024-12. Note that this case is often cited for its analysis of IRC § 2703 relating the ability to bind the IRS to business value under a buy-sell agreement. Although that is an important issue in the case and more broadly in tax planning, I will not discuss it here.
