You’ve built a strong business, one that represents your values of commitment to the customer, fairness to employees, and the virtues of hard work that is rewarded in the marketplace. You’re ready to exit and you’ve been speaking with potential acquirers. 

Now, you think you’ve found the right investor to buy your business and move forward with the company’s future, while you move forward with your own.

Assuming you’re able to agree on the price and terms of sale, it may feel like you’ve got the wind at your back. However, you need to plan carefully or you’ll discover a sudden and strong storm of tax implications around every corner. One of those points of risk is created by goodwill.

A taxable sale of assets by a C corporation, an S corporation that possesses earnings as well as profits, or an S corporation subject to gains tax, which is then followed by the liquidation or distribution of the sale proceeds to shareholders, can quickly create a double tax situation impacting both the company and the shareholders.

The most common solution to this is to structure the sale of a company as a stock deal, rather than as an asset sale. However, purchasers often prefer an asset sale. Here’s why:

•    Purchasers in an asset deal often gain higher depreciation and amortized deductions as a result of a stronger fair-market value basis in the acquired assets.

•    Purchasers in an asset deal can select which assets to purchase, whereas in a stock deal, all assets are sold with the company.

•    Purchasers in an asset deal can also select which liabilities, if any, to assume, whereas in a stock deal, the company is sold with all of its liabilities.

In short, an asset sale can give the purchaser far greater precision over exactly what to purchase, but in return it can put the seller at risk for an unexpected tax consequence.

So, how can you reasonably reduce your exposure to double taxation in an asset sale?

The most common approach is for the purchaser to make payments directly to the shareholders associated with employment, consulting or as related to agreements for noncompetition. These are only taxed once, since they are not part of the asset sale – but this still becomes ordinary income that is taxable in its own right.

Another, less common but perhaps more strategic approach is for a shareholder to sell his or her personal goodwill in a transaction that is separate from the asset sale (note that this is something separate and distinct from the company’s goodwill). So, what exactly is “goodwill”?

According to the IRS, goodwill is “the value of a trade or business attributable to the expectancy of continued customer patronage,” and that “[t]his expectancy may be due to the name or reputation of a trade or business or any other factor.”

Specifically, personal goodwill is goodwill that is owned by the shareholders of the corporation, rather than by the corporation itself. Personal goodwill exists when a portion of a company’s intrinsic value is directly related to the expertise, knowledge, reputation, technical skills, customer contacts and business relationships of a given shareholder.

There are additional factors used to determine the presence and scope of personal goodwill (for example, the presence of pre-existing employment contracts or noncompete agreements between the shareholder and the company may negate the presence of personal goodwill), but nonetheless it generally boils down to how the earnings and value of the company relate to (or rely upon) you personally.

Typically, an amount paid by the purchaser directly to shareholders associated with an existing noncompete agreement or for other contracted services is distributed as regular income to the shareholders and is taxable as such.

However, if the noncompete agreement is created as part of the sale of the business, then the noncompete’s value is considered part and parcel to the shareholder’s personal goodwill and these payments should be structured as a sale of goodwill.

Why, you might ask, should a business owner or shareholder go through all of this effort? The simple answer is: twenty-seven cents. A sale of personal goodwill is treated as a long-term capital gain and, therefore, is taxable at up to 23.8%, rather than being ordinary income taxable at up to 35% at the company level and, for any remaining amount, 23.8% at the shareholder level. The difference, on average, comes out to a savings of $0.27 on the dollar – an enormous difference. The reason they call it double taxation is, quite literally, that it can double your real-world tax liability (in this case, from 23.8% to 51%).

As with any complex tax strategy, you should consult with your CPA for professional counsel on the full range of considerations involved. Nonetheless, under the right conditions, a well-defined and properly executed sale of personal goodwill alongside an asset sale can make a huge difference.

Suddenly, personal goodwill is looking pretty great.

Selected Sources:

Goodwill as Part of a Corporate Asset Sale
http://www.aicpa.org/PUBLICATIONS/TAXADVISER/2014/MAY/Pages/Payne_May2014.aspx

Transfers of Personal Goodwill in the Sale of a Closely Held Business
http://www.cpa2biz.com/Content/media/PRODUCER_CONTENT/Newsletters/Articles_2007/CPA/Dec/HeldBusiness.jsp

Saving Taxes in Transfers of Personal Goodwill
http://www.journalofaccountancy.com/Issues/2007/Dec/SavingTaxesInTransfersOfPersonalGoodwill.htm

Exit Strategies – Minimize the Dreaded ‘Double Tax’
http://www.mypmp.net/2013/12/10/exit-strategies-minimize-the-dreaded-double-tax/

Image Credit: reynermedia (Flickr @ Creative Commons)