INSIGHT ARTICLE |
One of the more popular strategies for tax efficient merger and acquisition (M&A) transactions utilized by sellers, private equity and strategic acquirers alike is the purchase and sale of personal goodwill of the selling shareholder(s). The acquisition of a selling shareholder’s personal goodwill is tax efficient because it provides the acquirer with an amortizable tax asset while only being taxed once to the selling shareholder at preferential capital gains rates. The purchase and sale of personal goodwill is generally used in situations where the target is a C corporation, so the acquisition of the shareholder’s personal goodwill avoids corporate-level taxation. Transactions are also structured as personal goodwill acquisitions where the selling shareholder is looking to avoid the receipt of compensation, which is taxed at the higher ordinary income rates.
The recent Tax Court decision in James P. Kennedy et ux. v. Commissioner; T.C. Memo 2010-206, is the third straight win by the IRS against taxpayers claiming that payments received represented the acquisition of personal goodwill. This decision also highlights a potentially growing and concerning trend of taxpayers, particularly selling shareholders, claiming the sale of personal goodwill without properly analyzing or documenting their positions. In particular, the Tax Court was critical of a failure to value the goodwill, instead allocating 75 percent of the consideration to personal goodwill in what the Tax Court called a “tax motivated afterthought.”
Yet another significant and concerning part of the Tax Court’s decision was the analysis of Martin Ice Cream v. Commissioner, 110 T.C. 189 (1998). As with prior cases, the taxpayer relied primarily on Martin Ice Cream as support for his position. Despite the fact that the Tax Court held that the payments were not for the taxpayer’s personal goodwill, it went on to question, by way of noting that the Tax Court did not rule on the issue, whether the sale of personal goodwill in the Martin Ice Cream decision represented capital gain income. This line of reasoning by the Court is concerning in that it would significantly limit the benefit of personal goodwill to a seller by applying ordinary income tax rates to the payments. However, we are unaware of this position being successfully argued to the sale of goodwill in previous precedent.
What lessons can we learn? This recent string of IRS victories should serve as fair warning that the IRS is ready and willing to challenge the assertion of personal goodwill where the facts do not support it. Taxpayers, particularly sellers, wishing to take the position that an M&A transaction is the purchase and sale of personal goodwill should support the position with formal valuations of the personal goodwill and should receive qualified tax advice that properly documents the existence of personal goodwill, the seller’s ownership of the goodwill and the separateness of the goodwill from the goodwill of the entity.
To read more on the factors supporting personal goodwill and recent IRS challenges to the position, follow the link to our whitepaper, Personal Goodwill: Alive and Well