The concept of goodwill in a business sale is familiar to most business owners. The more the better, right? Personal goodwill (versus enterprise goodwill) on the other hand is less familiar, and trickier to deal with. If your small company (say up to around $10 million revenue) is structured as a C-Corporation, you should know about personal goodwill and how its existence could put more money in your pocket when it’s your time to sell. Here’s how it works.
The C-Corp Dilemma
Sellers of C-Corps prefer to sell the stock of their companies because it is more tax efficient than selling assets; yet the reality is that most of these sales are structured as asset transactions. 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. 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 be an advantage.
But for C-Corps, selling assets is usually 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¢. Could this happen to you?
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.
Allocating part of the purchase price to personal goodwill has been an arrow in our quiver for the past decade or so; however, it cannot simply be a post-closing purchase price allocation by the parties 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 of PGW 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.
This Sword has Two Edges
Selling any business with high personal goodwill is challenging. When goodwill goes home at night, valuation and marketability are generally reduced. 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.
Side-Step this Landmine
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 possibility of being double taxed when you are ready to sell.
Exit Strategies Group’s professionals dedicate themselves to staying abreast of potential tax breaks and pitfalls for private business owners as they carry out business sale, merger and acquisition transactions. Al Statz is founder and President of Exit Strategies and is based in Sonoma County California. For help or further information on this subject he can be reached at firstname.lastname@example.org or 707-781-8580.