In a recent Tax Court case (Bross Trucking, Inc. v. Commissioner, T.C., No. 7710-11, T.C. Memo. 2014-107, June 5, 2014), the question of whether goodwill and related intangible assets were corporate or personal in nature was the primary issue at hand. The Internal Revenue Service (“IRS”) contended that Bross Trucking, Inc. (“Bross”) made a taxable distribution of intangible assets to Chester Bross (“Chester” - the owner of Bross) on February 1, 2004, and that Chester made a taxable gift of the appreciated intangible assets to his three sons, who organized a new trucking company, LWK Trucking Co. The IRS assessed Bross Trucking with a corporate income tax liability of nearly $1 million and Chester individually with a gift tax liability of over $1 million. The primary issue before the Court was whether Bross truly owned any intangible assets of value that it could in fact distribute.
What is Personal Goodwill?
Personal goodwill is an intangible asset that is tied to the person as opposed to the business. In general, the value of the intangible assets of a business (including goodwill) is related to the market advantage that gives rise to expected earnings in excess of a normal return on the other operating assets of the business. Business goodwill value is evident to the extent that these advantages relate to assets owned by the business (i.e., patents, trademarks, etc.). On the other hand, to the extent that these advantages relate to an individual owner’s name, personal relationships, or personal reputation, then personal goodwill is evident. In other words, personal goodwill results when the excess returns earned by a company are due to the ability and efforts of the individual business owner.
In general, personal goodwill exists when the shareholder’s reputation, expertise, or contacts contribute significantly to the company’s value and future income stream. Personal goodwill can be manifested in the close personal relationships that exist between certain shareholders or another party and key decision-makers at customers or suppliers. It is most likely to be associated with businesses that are technical, specialized, or professional in nature, or have a few customers and suppliers. But as the fact pattern described in the Bross case highlights, these business attributes aren’t necessarily required in order for valuable personal goodwill to be present.
Prior Tax Court Cases Regarding Personal Goodwill
The concept of personal goodwill from an income tax perspective has been the source of controversy with the Internal Revenue Service for well over the last 20 years, since the seminal Martin Ice Cream and Norwalk cases were decided in 1998, with favorable outcomes for the taxpayers.1 In more recent years, a few court cases resulting in taxpayer losses have highlighted the issue.2
While each of the situations in these cited prior Tax Court cases were different, common general themes emerge regarding what factors the Court considers when analyzing the existence of personal goodwill versus business goodwill. The following is a summary of these general factors that generally support a higher allocation of value to personal goodwill:
Court Decision in the Bross Trucking Case
Citing Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, 209 (1998), the Court stated that a business can “distribute only corporate assets and cannot distribute assets it does not own. Specifically, a corporation cannot distribute intangible assets that are individually owned by its shareholders.”
In determining whether Bross owned any goodwill or other intangible assets, the Court examined the following facts:
In summary, the Court concluded that Bross had no trade name value, no value to its licenses, no unique supplier relationships, and no valuable assembled work force that was transferred. The Court ruled that “Bross’ established revenue stream, its developed customer base, and the transparency of continuing operations were all spawned from Chester’s work in the road construction industry.” Based thereon, and based on the fact that Chester did not have a non-compete or employment agreement with the company, the Court held that Bross wasn’t liable for a tax on the distribution of its goodwill to Chester, its sole shareholder, and that Chester wasn’t liable for a gift tax related to the subsequent transfer of assets to his sons because the company didn’t have any goodwill or other intangible assets to transfer.
When analysts and tax practitioners hear the term personal goodwill, they often think of insurance agencies, medical practices, small CPA firms, and other similar personal service companies. The decision in this case shows that whether the subject company distributes ice cream (i.e., Martin Ice Cream matter) or is a hauler of construction-related materials and equipment for road construction projects (i.e., Bross Trucking), the issue of whether goodwill is a corporate or personal asset is very case-specific to the facts at hand.
This issue also commonly arises in situations when a C corporation and the personal goodwill of its owner are collectively sold in an asset sale to a third-party buyer. There is a tax advantage to the seller in such situations if the facts support an allocation of a portion of the total purchase price to personal goodwill as opposed to corporate goodwill (by avoiding the double layer of taxation of C corporations). Understanding what assets of the subject company truly drive the revenue and Cash Flows that it generates is the key to answering the question of whether goodwill is a corporate or personal asset.