Financial conditions are clearly tightening. But, if you have clients thinking about selling their businesses, there’s no reason to rush the transaction. When the future is uncertain, successful entrepreneurs and their advisors are tempted to “get while the getting’s good.” But without taking the time to do the exit planning correctly, your clients could be leaving millions of dollars on the table.
When clients sell a company, especially if it’s a professional service firm or a company built from the ground up, they have an important, but misunderstood asset called “goodwill.” That’s the amount a buyer pays them above and beyond the fair market value of the business’ hard assets and liabilities. Some of the goodwill is “enterprise” goodwill and some is “personal” goodwill. In a minute I’ll explain why isolating personal goodwill can be highly advantageous for sellers.
Goodwill Hunting: Three Steps
Goodwill refers to the value of a business’s intangible assets such as customer or subscriber lists, patient lists and medical records, business, vendor and client relationships, etc. For federal income tax purposes, goodwill must be accounted for in tax filings and may attach to either the business or to the individual.
1. Ask your client if they have goodwill assets and whether the goodwill assets can be separated between “corporate goodwill” and “personal goodwill.” Corporate goodwill includes existing arrangements with suppliers, customers or others and its anticipated future customer base due to the business operations. 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 owner’s longtime name recognition in a geographic area or industry.
2. If a portion of the business sale price can be allocated to your client as a personal goodwill payment, ask your client if they’ll continue to work for the business after the sale or quit the business immediately. If leaving the business altogether, the amount your client receives for personal goodwill (that is, personally sold by them separately to the buyer) may receive favorable capital gains tax treatment and not be subject to self-employment tax. You must stress to your client the importance of documenting the purchase negotiations, the form and content of the transaction documents, the non-compete agreements between your client and the purchaser (and not between your client and the company they work for) and a qualified appraisal of the goodwill value.
3. If personal goodwill qualifies as a capital asset in the hands of your client who’s leaving the business for good, can your client contribute all or a portion of that asset to a charitable trust or to their children as a family wealth transfer? Based on recent Tax Court decisions and the facts and circumstances of your client’s situation, many Tax Courts view personal goodwill as an item of property that may be transferred. That’s preferable to viewing it as future earning potential for the individual who creates it, which can’t be transferred. See Bross Trucking, Inc., T.C. Memo. 2014-107, and Estate of Adell, T.C. Memo. 2014-155.
Why Care?
Here are seven reasons to care about goodwill:
- The sale of goodwill is taxed at capital gains rates, not at ordinary income rates.
- Buyers typically prefer an asset sale over stock sale (step-up basis, liability issues, etc.).
- Buyers can amortize purchases of goodwill under Internal Revenue Code Section 197.
- For C corporation (C corp) asset sales, personal goodwill sales aren’t subject to double taxation as they are with enterprise goodwill sales.
- For S corporation (S corp) asset sales, personal goodwill proceeds can be allocated differently than the pro-rata distribution of business asset proceeds.
- There’s no business entity-level gain on the sale of personal goodwill.
- There’s the opportunity to do individual-level tax planning with discrete asset transaction.
There are many different ways to transfer personal goodwill into a charitable vehicle. It depends on what your client is trying to accomplish. You can transfer the goodwill to your client’s kids if you want. You can sell it to a private placement life insurance policy in which it gets redeemed for cash with no tax liability. We’re doing a lot of goodwill to a charitable trust in which the goodwill gets bought, so 100% of the dollars are at work and the client gets a tax deduction for transferring it. Essentially, they’re giving the goodwill away, but retaining a lifetime income interest like they are for an appreciated stock.
Real World Example
I have a client who’s selling the assets inside a C corp. That means all the cash for which he sells the company will be taxed twice – first at the corporate level then at the individual level. However, if we can carve out the personal goodwill he’s built up in the company over the past 50 years, it’s no longer in the C corp. It’s his personal asset outside the company. But most people just allocate goodwill to the company; they don’t parse out the founder/owner’s personal side. It just becomes a purchase of assets that aren’t designated assets. And that’s ridiculous, because so much of the company’s success is based on the founder/owner’s hard work and reputation in the industry.
Determining the Amount of Goodwill
You can hire an appraiser to value the goodwill portion of your client’s company. But, if you can get an offer from an outside buyer in an arm’s-length transaction who’s willing to purchase your client’s company for a set amount, that’s even better. That way, your client meets the “willing-buyer/willing-seller,” test and the Internal Revenue Service will have a hard time contesting the $5 million your client claims they received for personal goodwill and its favorable tax treatment. Unfortunately, many owners and their advisors don’t understand this concept.
Another challenge is that the majority of founder-owned businesses are S corps and your client generally can’t do much charitable planning with S corps. But if your client carves out the personal goodwill portion of the S corp. assets, they can transfer those assets separately to charity and then have the charitable trust sell them. The seller gets a substantial deduction, and it doesn’t cost the buyer anything additional.
Some of the best advice I got early in my career was: “Take your time, take a breath.” It still applies today. After all, it’s not about how much your clients sell their businesses for; it’s about how much they get to keep after taxes and transactions costs. The price tag itself is just a vanity plate.
It’s flattering when someone offers your client $20 million for a business that they spent their whole life building. But, if they live in Massachusetts or another high tax state and they’re a C corp, how much are they really going to get to keep? They’re tax hit alone could be $8 million. That’s where charitable planning comes in.
Leveling the Playing Field
Selling a business is a once-in-a-lifetime event for most owners. But buyers do transactions all the time. Who do you think has the edge in the negotiation process whether it’s a strategic buyer or a private equity firm? It’s especially one-sided when you consider that owners tend to bring their longtime accountant, attorney and other advisors to the table who have limited transaction experience. It’s like bringing a knife to a gun fight. That’s why you want to bring your best possible team to the table, including a specialist in charitable planning.
Differentiate Yourself
When you help your client sell their service-related business in a financial and tax-wise way, by using charitable trusts and strategic personal goodwill allocations, you can truly differentiate yourself from your competitors.
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.