The sale of a C corporation business that is structured as an asset sale is subject to two levels of tax. There is a tax on the corporation (21% federal) and a tax on the shareholders when the sales proceeds are distributed (20% federal). By comparison, on a sale of stock, a shareholder is only subject to a tax of 20% (federal).
In some cases (admittedly not common), the goodwill of a business may be more appropriately treated as owned by a shareholder rather than the corporation itself which is known as personal goodwill. For instance, if the portion of the asset purchase price attributable to goodwill is $2 million but $1 million is personal goodwill of a shareholder and purchased directly from her, she would save $210,000 of federal income tax.
Generally speaking, personal goodwill exists when the success of the business of a corporation is attributable in substantial part to the reputation or the relationships of one or more persons (e.g., an owner/employee) and the owner has not effectively transferred the goodwill to the company by entering into a noncompete or employment agreement that prevents them from using their reputation or relationships to compete with the company. While the IRS has acknowledged the principle of personal goodwill, it will closely scrutinize it if audited so careful planning is advisable.
The shareholder should be prepared to demonstrate, that the success of the company is in fact dependent on his or her reputation or relationships. It is advisable to obtain a third-party determination of the value of the personal goodwill at or prior to the sale. The documentation for the acquisition should clearly reflect that consideration is being paid to the shareholder for their personal goodwill and the seller should enter a consulting or employment agreement with the buyer.
Bottom Line: When the facts are right, the sale of personal goodwill may be an opportunity to save a substantial amount of tax in a C corporation asset sale.
“The only difference between death and taxes is that death doesn’t get worse every time Congress meets.” – Will Rogers