The concept of goodwill in a business sale is familiar to most business owners. The concept of personal goodwill (versus enterprise goodwill) is less familiar. Today I want to discuss what personal goodwill is, how it benefits the seller(s) of C-Corporation businesses, and what’s involved in selling it.
The C-Corp Dilemma
Sellers of small (up to about $5 million revenue) C-Corps generally prefer to sell the stock of their companies because it is more tax efficient than selling assets; yet the reality is that around 90% of these transactions get structured as asset sales. Why? Because, for buyers, buying assets reduces their tax bill, improves their cash flow, and reduces potential legal liabilities. Astute buyers that are asked to forgo these important benefits (i.e. you require them to buy stock) will expect a substantial price discount, and some will just walk away.
For an S-Corp on the other hand, which is a pass-through entity, selling assets (vs. stock) usually isn’t a much of problem from a tax perspective. In some cases, selling assets can even be an advantage.
But for C-Corps, selling assets is a big disadvantage. Here’s a simple example. Assume that the combined federal and state C-Corp income tax rate is 29%, and that the combined individual capital gain tax rate is 28%. In an asset sale, for every $1.00 of transaction price (above book value of assets), C-Corp shareholders net only 51¢.
Does the Goodwill Go Home at Night?
Goodwill value is that portion of a business purchase price that exceeds net tangible asset value. Personal goodwill (“PGW” for short) differs from enterprise goodwill in that PGW represents the value of an owner’s personal service to that enterprise, and is considered an asset owned by that person, not the business. PGW value is usually the result of an individual’s outstanding reputation and close personal relationships with customers and/or suppliers, or exceptional rainmaking or technical mastery, and other unique abilities that directly produce economic benefit for the business.
When PGW is present, the success and value of a business are largely dependent upon one or two key individuals, usually the owner(s) in a small business. Without the key individual(s), the business may have little value. In other words, the goodwill goes home at night!
Personal Goodwill Presents a Tax Savings Opportunity
In asset sales of small owner-operated corporations, there can often be two sellers: (a) the business entity, and (b) an individual selling his or her personal goodwill. Selling PGW creates a tax savings opportunity for C-Corp owner-operators.
Using the same tax rates as above, for every $1 of transaction price that can be allocated to personal goodwill, the seller’s tax savings is 21¢. This is because the $1 allocated to PGW does not get taxed at the C-Corp level (is not “double taxed”). Suppose that in a $2 million transaction, $800K can be allocated to personal goodwill. This reallocation puts $168K more in the seller’s pocket.
Devil in the PGW Details
Allocating part of the purchase price to personal goodwill has been an arrow in the quiver of M&A brokers like us for the past decade or so; however, it cannot simply be a post-closing purchase price allocation by CPA’s. Rulings in several tax court cases demonstrate that PGW is under consistent attack by the IRS.
When a C-Corp seller is considering allocating a portion of a sale price to personal goodwill, these are some of the norms for supporting the existence PGW of apart from enterprise goodwill, and having a PGW allocation hold up to IRS scrutiny:
- There must be a separately negotiated PGW purchase agreement with the buyer. As brokers, we plan for this with the seller and buyers, before an offer is made. We coordinate with the parties’ attorneys and CPA’s of course and let lenders know that the final paperwork will change.
- There must be a separate paid for covenant not to compete with the seller.
- The buyer must have access to the seller’s personal goodwill through a written employment/consulting agreement for an extended term, with market-based compensation.
- The amount allocated to PGW must be based in economic reality. Though the valuation of personal goodwill is still more art than science, a third-party PGW valuation should be obtained to substantiate and set the final allocation.
No doubt, selling any business with high personal goodwill is challenging, and having a C-Corp structure adds yet another layer of difficulty (and expense) because of double taxation. Working with an experienced M&A broker, transaction attorney and CPA is extremely helpful when buying or selling this type of business.
Better yet, if you own a C-Corp business and your expected holding period is 5 years or more, talk to your CPA now about converting to S-Corp status so that you can avoid the double tax when you sell.
Al Statz, founder and President of Exit Strategies Group, is based in Sonoma County California. For help or further information on this subject he can be reached at email@example.com or 707-781-8580.