Introduction
In many circumstances, a portion of the goodwill of a business enterprise can be said to belong personally to individual company owners or employees rather than to the business entity itself. Recognition of this fact can have important financial consequences in certain tax valuation situations. It also is an issue that arises frequently in matrimonial equitable distribution valuation matters.
What is Goodwill?
Goodwill has a number of definitions. For the purpose of this discussion, however, it can be said that goodwill is that portion of the value of a business which lies above and beyond the value of its definable tangible assets. A restaurant, for example, has tangible physical assets that have value (furniture, fixtures, real estate, etc.). It can also has an element of value, however, that is based upon its intangible attributes, such as its name, location, reputation, the personal characteristics of its staff and the like. This intangible-based portion of the restaurant’s value is called goodwill.
What is Personal Goodwill?
Continuing with the restaurant as an example, it is often the case that a portion of a restaurant’s success and its goodwill value is attributable the personal characteristics of people, such as the skill and renown of its chef, or to the personality of its maitre d’. The value that is attributable to the skills, experience or reputation of individuals, rather than to the business entity itself, is known as personal goodwill. The balance of the businesses goodwill value, which is related to and owned by the company itself, is called entity or corporate goodwill.
Personal Goodwill versus Corporate Goodwill – Sale of a Company
In certain corporate acquisition transactions, there can be important differences in the tax treatment of a sale depending on whether the goodwill being sold belongs to the selling shareholder personally, or to the selling corporation. If the goodwill is owned by the selling shareholder, and is being sold directly by him to the buyer, there will be only a single level of taxation on that portion of the transaction. If, however, the goodwill were deemed to be owned by the selling corporation and not by the selling shareholder, it is possible that the sale of the goodwill by the corporation to the buyer would generate a corporate level tax, and that the net proceeds of the corporate sale, when distributed to the shareholder, would be taxed again. In other words, the sale of same asset would be taxed twice. It can be seen, therefore, that in such circumstances it can be a matter of some moment to the seller whether goodwill is treated as a personal asset or a corporate asset.
Personal Goodwill versus Corporate Goodwill – Matrimonial Equitable Distribution
The issue of personal versus company goodwill arises with some frequency in matrimonial matters. The laws of the various states differ as to whether personal goodwill (such as the professional goodwill of a lawyer or physician) should be included in the marital estate for purposes of equitable distribution. Some observers believe that to deem personal goodwill of the propertied party as a marital asset subject to division, and to also include future personal income derived from the same personal goodwill in determining of the level of maintenance or support payments is “double counting” the same asset.
How does one value Personal Goodwill?
A business appraiser may be called upon to determine whether a business has goodwill, and if it does, what portion can be deemed to be personal goodwill.
One common approach to determining the value of personal goodwill is to measure the portion of the value of an entity’s profits or cash flow which is attributable to skills, experience and relationships of a particular employee. The appraiser, in effect, determines what the value of the business would be with and without the services of the particular employee. The difference between the two values is arguably the value of that employee’s personal goodwill.
The valuation analysis must at the end also pass a reasonableness test. The total of the personal goodwill, the company goodwill, and the tangible asset valuations must bear a reasonable relationship to the value of the company as a whole.
Does Personal Goodwill sometimes belong to the Company?
Yes. If an employee has entered into an employment or non-compete agreement with his employer, he arguably has, in effect, transferred his personal goodwill to the company. It is then an asset of the company and in the event of a sale, can be subject to the double taxation referred to above. A leading tax case in the area of personal goodwill is Martin Ice Cream v. Commissioner, 110 T.C. 189 (1998). Another is Norwalk v. Commissioner, T. C. Memo 1998-279. A more recent case is Howard v. U.S., No. 2:08-cv-00365 (E.D.Wash. 7/30/10).
Conclusion
In a merger and acquisition situation, or a matrimonial property matter, it is worthwhile to give a more-than-passing thought to the question of who owns the goodwill assets of the enterprise. A proper allocation can prevent some unintended consequences. A business appraiser can be of considerable assistance.
