September 01, 2014

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:

  • No non-compete agreement exists between the subject shareholder and the company
  • Business is highly dependent on individual’s personal relationships, reputation, skills, and know-how
  • Individual’s service is important to the sales process
  • Operations in which shareholders are highly involved
  • Businesses with few and high-volume customers
  • Companies that are highly technical, specialized, or engaged in professional services
  • Companies that have contracts that are terminable at will
  • Companies with a high percentage total asset value being comprised of intangible assets
  • Loss of key individual would negatively impact the revenue and/or profitability of the company

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:

  • Chester had close personal relationships with Bross’ primary customers.
  • Chester had no non-compete agreement that would prohibit him from competing with the company if he disassociated with it.
  • The value of Bross’ licenses was not significant given that it was relatively easy for new market participants to obtain trucking authority and comply with other regulations in Missouri.
  • Bross had recently been under investigation by the Department of Transportation (“DOT”) and the Missouri Division of Motor Carrier and Railroad Safety. Bross received significant negative publicity from the audits, and the continued heightened regulatory scrutiny posed the risk that Bross would be put out of business; this risk caused Bross’ customers to reevaluate whether to trust Bross with their business.
  • Given the recent regulatory investigations, the value of the Bross trade name was not significant and was in fact negative. Contemporaneous proof of this was that Chester’s sons’ newly formed company — LWK Trucking — hid the Bross name on all of its trucks with magnetic covers.
  • Bross had no significant unique supplier relationships that allowed the company to generate superior returns. The Court noted the fact that the relationships with suppliers of fuel and parts largely resided with Chester himself.
  • Bross relied on independent contractors to perform hauling services. Given this fact and the fact that only 50% of LWK Trucking’s employees were former Bross employees after the transfer, the evidence pointed to the fact that LWK Trucking assembled a work force independent of Bross. LWK’s work force consisted of new key employees — some of whom allowed LWK to extend new service offerings that were distinct from those that Bross offered.

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.

Observations

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.