The Purchase or Sale of Goodwill - Let's Make It Personal

Editor's Note: Christopher D. Foster is a member of the Business Section of Ward and Smith, P.A.

In buying or selling the assets of a business, a major component of the transaction is the allocation of the purchase price among assets, including goodwill. In recent years, however, judicial decisions have created a new class of goodwill – personal goodwill – which receives more favorable tax treatment to the seller than ordinary business goodwill. Personal goodwill also can become part of a stock purchase, although the tax benefits most likely will be available only to the purchaser.

What Is Goodwill?

Goodwill is an intangible asset that consists of the value of a business that exceeds the value of the physical assets used in the business and its accounts receivable. In most cases, goodwill is associated solely with the business's reputation, patronage, and other intangible assets considered when appraising the business, and is referred to as "business goodwill." However, goodwill also can attach to a business owner when part of the business's intrinsic value can be attributed to the owner's personal skills, specialized expertise, reputation, or relationship with customers. Goodwill derived from the personal attributes of the owner is referred to as "personal goodwill." Personal goodwill is a judicially recognized concept that may provide valuable economic advantages in the sale or acquisition of a business.

As an example of personal goodwill, consider that customers shopping for a tool likely would find the best price for the tool at a national hardware chain. However, some customers may decide to frequent a local hardware store because of the familiarity and comfort with its owner. If the owner were to leave the store, the store likely would lose many of those customers and the business of the store would lose some of its intrinsic value. That lost value is the personal goodwill of the owner.

How Do I Know If I Have Personal Goodwill?

Identifying personal goodwill and separating it from business goodwill often is difficult and always is determined on a fact specific basis. One way to assess personal goodwill is to examine the overall influence an owner has on the business's future success. The more the business depends on the owner's personal relationships, knowledge, and skills, the greater the personal goodwill. Thus, personal goodwill often is found in professional businesses or closely held businesses, but there are a number of factors that must be considered. Some of the factors likely to indicate the existence of personal goodwill are:

• Small closely held business highly dependent on the owner's personal skills and relationships;
• No pre-existing covenant not to compete or employment agreement between the selling business and the owner;
• A crucial selling feature in the business's product or services is personal service;
• There is no significant capital investment in either tangible or identifiable intangible assets;
• Only employees own the business;
• Sales largely depend on the owner's personal relationship with customers;
• The owner has exceptional knowledge regarding the product or service;
• The business is highly technical or specialized; and,
• The business has very few customers or suppliers.

In any acquisition of a business, it is very important for the purchaser to investigate the target business (commonly known as performing due diligence) before acquiring such business. If the purchaser determines that any of the above factors exist, then efforts should be made to determine the appropriate allocation of the purchase price to the personal goodwill, as such allocation can have important tax benefits for both the purchaser and the seller.

What Are The Benefits of Personal Goodwill?

Some courts have ruled that personal goodwill is property that can be bought and sold. If personal goodwill is deemed to be property, then the recognition of personal goodwill can have important tax benefits for both the purchaser and the seller. Although the Fourth Circuit and the North Carolina Department of Revenue have not provided guidance on personal goodwill, other judicial jurisdictions in the past three years have recognized personal goodwill as an intangible asset in business acquisitions.

If the purchaser decides to buy the assets of a business in which the owner possesses personal goodwill, the purchaser can buy both the business assets and the owner's personal goodwill. The purchase price allocated to each of the assets will be the basis of that asset for the purpose of depreciation/amortization deductions. If personal goodwill is considered an asset, then, the purchaser's basis in the personal goodwill will be that portion of the purchase price allocated by the parties to the personal goodwill, and the purchaser can receive amortized tax deductions on the personal goodwill.

Should the purchaser buy the stock of a corporation that possesses personal goodwill, the purchaser also can receive tax benefits. Although the purchaser will not be able to take any deductions on the stock purchase, the purchaser's basis in the personal goodwill will be that portion of the purchase price allocated by the parties to the personal goodwill, and thus the purchaser can receive amortized tax deductions on the personal goodwill.

From the seller's perspective, personal goodwill is subject to long-term capital gains treatment. In contrast, any amount allocated to the sale of business goodwill is subject to ordinary income treatment. Thus, the seller of personal goodwill will receive a greater tax benefit for the amount allocated to personal goodwill. In a sale of stock rather than assets, there will be no difference in tax treatment, both personal and business goodwill being long-term capital gains.

Because characterizing goodwill as personal or business can be quite difficult, purchasers and sellers should take precautions to protect themselves in the event the IRS or the North Carolina Department of Revenue attempts to reallocate personal goodwill to business goodwill. Clearly, a professional appraisal prior to sale will be useful in defending the allocation, but the purchaser also may want to include indemnification provisions in the purchase agreement. Additionally, transactional insurance may be available to protect the purchaser or the seller in the event the IRS or the North Carolina Department of Revenue reallocates the personal goodwill to business goodwill.

Conclusion

In most sales of businesses, goodwill may account for a substantial percentage of the value of the business. However, parties to such transactions often are unaware that goodwill may be characterized as business goodwill or personal goodwill. If personal goodwill is recognized as marketable property, both the purchaser and the seller of a business can be the recipients of certain tax benefits. Further, the ability to allocate part of the purchase price of a business to personal goodwill may help facilitate a transaction that is floundering due to various tax considerations. Because of the difficulties associated with allocating personal goodwill, however, the purchaser and the seller should take certain precautions in the event the personal goodwill is reallocated to business goodwill.

Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Christopher D. Foster practices in the Business Section, where he concentrates his practice on business and corporate matters and taxation. Comments or questions may be sent to cdf@wardandsmith.com.

©Ward and Smith, P.A., 2008

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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