Selling Your Business?  Personal Goodwill Can Reduce Your Tax Burden

Selling Your Business? Personal Goodwill Can Reduce Your Tax Burden

John M. Goralka, Kiplinger Consumer News Service (TNS)

Most people, including many experienced attorneys and CPAs, are surprised to learn that a sole proprietor, shareholder, or member can individually own a bundle of rights in a corporation or limited liability company, commonly known as goodwill.

The same corporation or company can have both corporate goodwill and personal goodwill. Most of the early cases in this area arose in the context of a divorce where the ex-spouse sought compensation or property at the time of the divorce. Careful planning can leverage these individual ownership interests to provide significant tax savings in the event of a sale of a corporation or company. We recently used individual ownership of goodwill to save our client over $1.2 million in sales taxes and a secure, predictable income stream of $180,000 per year for the life of him and his spouse.

Virtually all states recognize the existence of a business owner’s personal goodwill as a separate asset or property right. This goodwill ownership provides some unique planning alternatives to minimize the income tax associated with a corporate or company acquisition. This article shows how personal goodwill planning can be used to minimize tax on the sale of a corporation or company.

The importance of state law

Our analysis begins with state law. The Internal Revenue Code (IRC) assesses taxes on both assets and property rights on income. However, those property rights are actually determined by applicable state law. When IRC transactions are taxable, applicable state law defines and regulates those property rights.

Although the IRC does not have an actual definition of goodwill, it does refer to it. IRC Section 197 provides for and controls the amortization of intangible assets, including goodwill. State law recognizes that the goodwill of a corporate or company business may be attributable to individuals rather than just the business. State law further recognizes that goodwill is a property right or asset that can be transferred in the same way as equipment or other assets. Some cases that define and describe goodwill as a property right are found in divorce cases where a spouse seeks compensation for a property right.

Because individual state law recognizes goodwill as transferable property to one degree or another, the IRC uses that state law to determine the tax attributes of goodwill. A reference to “company or enterprise goodwill” usually refers to the goodwill of a business or enterprise. Personal goodwill usually refers to goodwill that belongs to the business owner or another person. More specifically, personal goodwill generally reflects the personal skills, reputation, and personal customer, vendor, and referral relationships of the business owner or other individuals.

Unique tax advantages

The most well-known use of personal goodwill is to minimize tax on the sale of a C corporation. An AC corporation is a corporation taxable under subchapter C of the IRC. This means that the corporation pays income tax at the corporate level. When income is distributed to shareholders or owners as dividends, the income is subject to secondary taxation. This is especially important because many corporate sales are structured as asset purchases. There are at least two reasons for this.

First, buyers often want to be protected from seller liabilities that may arise during a stock sale. Second, to obtain capital growth by allocating the purchase price to depreciable or depreciable assets. Depreciation or depreciation can provide significant tax benefits for the buyer. Note that this may result in higher tax for the seller due to depreciation recapture.

For example, a $6 million C corporation asset sale may have the following tax consequences. $2,058 million in corporate-level taxes for federal and state purposes. When income is distributed to shareholders or individuals, $1,971 million is taxed. The combined corporate and individual tax rate can exceed 70% for federal and state tax.

Instead, if $2 million is allocated to personal goodwill, this amount is taxed as a capital gain to the business owner, resulting in a savings of over $1 million because personal goodwill is not subject to a corporate tax rate above 30% and is only taxed as capital gain at the individual level. is taxed.

A lesser known program

A lesser-known program is for the sale of a subchapter S corporation. An S corporation is taxed under Subchapter S of the IRC. A subchapter S corporation does not pay federal taxes at the corporate level. Income is taxed similarly to a partnership. (There are a few differences, such as not being able to make a 754 election for a step-up based on the death of a partner.) The taxation of goodwill is not subject to second rate taxation and is already characterized as capital. an asset taxed at a more favorable capital gains tax rate.

However, some of the best tax minimization strategies involve transferring a portion of the asset to a charity before the sale. (Please see my article: A Tax Planning Cautionary Tale: Timing and Formalities Are Crucial to learn how. no Doing so.) This will ensure that there is a portion given in charity no is taxed and provides a charitable contribution deduction to minimize tax on the remainder of the sale.

A recent sale of the business for $6 million resulted in over $1.4 million in tax savings. This was done by making a personal goodwill contribution to a lifetime income charitable pooled trust prior to the sale. In addition, the seller was able to invest and receive the amount he gave to the distributed interest charitable income fund for life.

This provided very significant economic benefits for the family as follows:

This lifetime income charitable pooled trust can provide a significant increase in family wealth simply by paying taxes. If we just pay taxes, then the family will make $2.25 million after federal and state taxes of (approximately) 25%, or $750,000. If 7% is invested, this will yield $157,000 per year. This provides a value of $1,668,557. When added to the $2.25 million, this provides a total increase in wealth of $3,918,557. If we avoid tax on that same $3 million, we save $750,000 in taxes and invest the entire $3 million to generate a safe, predictable income of $210,000 each year. If invested for 20 years, this is worth $8,609,053. It has a preset value of $2,224,743. When the $3 million from the sale is added to the net income, this provides a predetermined value of $5,224,743. This represents an increase in wealth of more than 33%.

In addition, the client received an income tax credit of $2,202,641 to avoid tax on other income. The total tax savings was $1,564,977, which reflects the tax savings before the deduction and the non-taxable charitable portion of the sale. This provides significant benefits to the family, especially when added to the investment income described above.

Tax situations

One of the leading cases in relation to tax advantage and personal goodwill Martin Ice Cream Co. v. Commissioner, where Arnold Strassberg sold the assets of Strassberg Ice Cream Distributors Inc. to Häagen-Dazs. These assets include intangible assets, including his personal relationships with supermarket owners and managers. The Tax Court recognized that these intangible assets were personal goodwill owned by Strassberg as an individual, not a corporation or entity. The main factors cited by the Tax Court were that Strassberg never competed with or entered into an employment agreement with his company, Strassberg Ice Cream.

A similar result was found in H&M Inc., TC Memo 2012-290, where a sole proprietor never entered into an agreement with his corporation prior to the sale of the business, preventing him from taking his personal relationship skills and business relationships to a competitor. or another company.

What you need to know

Emphasis should be placed on developing and documenting the business owner’s personal experience, skills, and availability of customer vendor and referral relationships. Confirm that the business owner has never entered into or executed a non-competition or restrictive covenant with the corporation or company being sold before for sale.

The buyer and seller must negotiate and determine the amount or purchase price for the goodwill transferred. Consider using a separate sales agreement between the buyer selling their personal goodwill and the business owner.

Personal goodwill must be transferred to a separate LLC before the sale. If a contribution to a charity is to be made, it must be made before a binding agreement is reached between buyer and seller.

Perhaps the best definition of value is an amount determined by an unrelated buyer and seller. However, the contribution is reported on IRS Form 8283. This form requires an appraisal for all contributions to the property.

As mentioned above, a little planning can provide significant tax savings and increase the wealth retained when selling a family business.

ABOUT THE AUTHOR:

John M. Goralka is the founder of The Goralka Law Firm.

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All contents copyright 2024 The Kiplinger Washington Editors Inc. Distributed by Tribune Content Agency LLC.

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