Personal Goodwill: A Tax Strategy
A company's "goodwill" is the difference between the current value of the tangible assets and the overall value of the business. Goodwill is the intangible portion of the business value. The amount designated for corporate goodwill will depend on the customers loyalty to the brand, the extent of the customer base, patents, trademarks, along with proprietary processes and technology.
When a business is being financed there is a portion of the financing that can address the intangible asset. If the business loan will involve an SBA guarantee, there are limits to the amount of goodwill that can be financed by the lender. Goodwill exceeding the government regulations may need to be carried as a business note by the seller.
When a business is being sold a strategy to reduce the tax liability of the seller is to allocate a portion of the goodwill as “personal goodwill.” The amount allocated for personal goodwill depends on how long that business has been operated by the same the owner and the loyalty of the customers and suppliers due to the owner (not the brand).
A business owner who has been an active member of the community, a volunteer in local charities, and has an excellent personal reputation creates personal goodwill. A business owner who is selling the business and is going to work for the buyer during a transition period to help retain customers has more goodwill than one that is going to leave the keys to the front door and walk away the day the transaction closes.
Personal goodwill has been determined to be if the company’s customers would follow
the “person” should the business seller decide to open a similar business after selling the current business. A doctor, accountant, or attorney’s business may thrive based on their personal
reputations and not on other business aspects. It is their unique personal characteristics that bring value to the business, thus it is considered personal goodwill.
A professional practice or service business has more flexibility in claiming personal goodwill due to the personal nature of the business. With these types of businesses the customers feel they are dealing with the person and not a corporate entity. However, this does not exclude other types of businesses who are considering using personal goodwill as a tax strategy.
Allocating a portion of the purchase price of the business to personal goodwill allows for the transaction to be structured for the tax benefit of the seller. Without this strategy the seller may be in a position of double taxation. The seller would have tax liabilities at the corporate level and then again at the personal rate when funds are distributed to the seller. Using the personal goodwill strategy, a portion of the funds received from selling the business can be allocated to personal goodwill and taxed at a capital gains rate, which is currently substantially lower than the corporate or personal tax rates. The percentage of additional funds the seller could deposit in the bank should be appreciably more with this strategy than without it.
However, the IRS keeps close tabs on these transactions and the decision to allocate funds for personal goodwill can be challenged and denied by the government if there is not proper documentation detailing the business value and importance of the seller as the key ingredient to the company’s success. If the IRS determines that the personal goodwill was a last minute strategy to reduce the tax liability it will be denied. Historical documentation, along with a proper analysis and business valuation are necessary.
With the proper documentation in place, the buyer won’t pay any more for the intangible asset, but the seller can deposit more due to lower tax liability. During the purchase and sale negotiations this could provide some extra room in the discussions when selling a business during troubled economic times.
When a business seller is considering the personal goodwill strategy, they must determine how much of the intangible asset can be attributed to the person. Note that 100% of the goodwill allocated to personal goodwill won’t be allowed and will definitely raise red flags. Seek out the proper guidance before finalizing a decision regarding the use of personal goodwill as a tax strategy.
1. Tangible assets such as real estate and equipment are easier to appraise.
Intangible assets have more room for interpretation when it comes to their value, so use a business valuation expert that
has experience in that specific industry.
2. If the transaction involves an international company be aware that accounting practices and the allocation of goodwill are not the same for each country.
3. Because tax laws can change, seek professional advice from experts who have experience in the allocation of personal goodwill.
4. If the buyer will not agree to the allocation for personal goodwill, instead of all the acquisition funds being provided in a lump sum, they may be willing to pay the seller as a consultant, or even an employee for a limited time, or provide funds in the form of a fee for a non-compete agreement. These strategies will also reduce the tax liabilities, but not to the extent an allocation for personal goodwill would provide.
5. For tax strategies involving personal goodwill remember: documentation, documentation, and documentation.
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