As part of our ongoing series on tax issues for accounting firm transactions, this article discusses the benefits of utilizing personal goodwill in accounting firm M&A deals when appropriate.
Personal goodwill refers to the reputation, relationships, and other intangible assets directly attributable to an individual professional rather than the business entity itself. It is especially relevant for professional service firms as these businesses thrive on their ability to offer unique services attributed to their owners’ advanced education and special skills. Courts have long recognized that personal goodwill is a salable asset that, given the right circumstances, can potentially (i) be separately sold by individual professionals alongside the sale of a broader professional practice (including with any corporate or business goodwill) and (ii) inures solely to the individual professional.
In planning for a transaction, accounting firm owners should carefully consider whether material value of the business could be attributable to owners’ personal goodwill instead of goodwill within the legal entity. When an owner’s expertise, referral abilities, network, and reputation in the market create significant value, that personal goodwill value may inure to that individual owner rather than to the business itself (with some exceptions discussed below). In other words, in certain circumstances, goodwill can be an individual asset, distinguishable from a corporate asset, which can be sold separately alongside any corporate asset. The IRS has expressly recognized the existence of personal goodwill in the absence of a strict covenant not to compete.1 Thus, where the business depends on its key employees and there is no evidence that such goodwill became property of the corporation or acquiring corporation, personal goodwill may be established and can have transactional benefits.
Tax Implications of Goodwill’s Characterization as a Personal or Business Asset
Most of the value of a professional services firm is attributable to goodwill, and its characterization as personal goodwill or business goodwill can have significant ramifications. If, for example, upon a sale of an accounting firm, these valuable intangibles are deemed assets of the business and not the individual, depending on the structure of the business, tax inefficiencies can arise. For firms that are C corporations, the characterization of goodwill as an asset of the business subjects the sale of such goodwill to double taxation. A separate sale of personal goodwill of the C corporation shareholders would only trigger gain at the individual shareholder level, allowing for additional tax savings over transactions characterized solely as corporate goodwill.2
Additionally, in an S corporation context, proceeds from an asset sale must be distributed pro-rata, which may conflict with the intended economics of the deal. However, a bifurcated sale of personal goodwill from certain of the selling shareholders would potentially allow for a portion of the overall transaction value to be attributable to those “rainmaker” shareholders in a transaction that would otherwise run afoul of the S corporation pro-rata distribution rules. As such, allocating personal goodwill to certain S corporation shareholders can provide valuable flexibility against the otherwise rigid S corporation rules around shareholder distributions resulting from an asset sale. Although the issue of goodwill ownership can arise in any transaction, including those involving S corporations, the tax issues are generally more acute in transactions involving C corporations. With careful planning, characterizing goodwill as personal versus an asset of the business can have significant benefits to selling shareholders.
Planning for the Sale of Personal Goodwill
Ideally, planning for the potential sale of personal goodwill should begin well before the entry into a definitive sale agreement. If possible, the parties should indicate the potential sale of personal goodwill in a letter of intent. Well-established case law3 says that an employee-owner entering into certain restrictive covenants is equivalent to transferring the personal goodwill of that individual to the corporation. If any such agreements exist, advisors should consider whether they can be effectively revised or terminated well in advance of a sale.4 Counsel should review relevant documentation to ensure that the shareholders have not potentially transferred ownership of their personal goodwill to the business by entering into long-term personal service or employment agreements containing restrictive covenants.
Even so, there is a risk that the cancellation or expiration of these agreements would not enable the employee-owner to receive their personal goodwill back tax-free from the corporation since the IRS could attempt to recast the cancellation of the agreement as a deemed taxable distribution of the company intangibles back to the employee-owner. However, if any such restrictive covenants do exist in the business, an element of personal goodwill may still apply, and counsel and valuation consultants should be engaged to consider many additional factors.5 In this context, there may be an argument that there is value to personal goodwill notwithstanding the existence of certain restrictive covenants, as the reputation alone of the professional who transfers to the buyer’s firm should carry some incremental intangible value.
1Technical Advisory Memorandum 200244009, citing the Martin Ice Cream case, involved a sale of medical practice assets to an unrelated physician practice management company through the use of several corporations and a transitory partnership, the Service ruled that “the goodwill associated with the shareholder cannot be a corporate asset in the absence of an employment/noncompete agreement between the corporation and the shareholder.”
2 It is recommended to have a supportable valuation performed by a third-party appraiser when allocating overall transaction value to the personal goodwill of the owners. Valuations can become complex with respect to the extent to which the business’s success is dependent on the individual’s personal attributes among other factors.
3 See, e.g., Howard v. US, No. CV-08-365-RMP (E.D. Wash. 7/30/10).
4 See Norwalk v. Commissioner, 76 TCM (CCH) 208 TC1998. The case dicta suggests that noncompete provisions will not preclude a finding of personal goodwill provided the agreements have been terminated before the sale to a buyer or are rendered unenforceable.
5 Id. Norwalk and other cases note that the value of personal goodwill may be impacted by the noncompetition and/or nonsolicitation agreements with key employees, the Court does not preclude a finding that personal goodwill exists.
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