3 Ways Personal Goodwill Can Help Business Owners Save Money – Portland Business Journal

3 Ways Personal Goodwill Can Help Business Owners Save Money – Portland Business Journal
July 13, 2020 Alina Niculita
Business valuation - personal goodwill

3 Ways Personal Goodwill Can Help Business Owners Save Money – Portland Business Journal

The Portland Business Journal published Alina Niculita’s article on July 10, 2020 in the Financial Services Guide.

It seems counterintuitive that personal goodwill, a potentially very valuable asset, would help a business owner save money in taxes and other payments. But with the right legal, tax, and business valuation planning, it is possible. Below are three examples of areas in which this personal asset can save business owners money. But first, what exactly is goodwill and personal goodwill?

Goodwill

Simply put, goodwill is part of the overall business value and it represents all the intangible value of a business. Most business owners understand goodwill as the portion of the business value that is not shown on the financial statements.

The Internal Revenue Service defines goodwill as “the value of a trade or business based on expected continued customer patronage due to its name, reputation, or any other factor.”

Not all businesses have goodwill, but for those who do, goodwill may be further divided into enterprise goodwill, an asset that belongs to the business, and personal goodwill, an asset that belongs to an individual, such as an owner, a shareholder, or an employee.

Personal goodwill

Personal goodwill is the portion of the business value that is due to the individual’s personal qualities such as:

  • Professional reputation and personal success.
  • Personal relationships with customers or suppliers.
  • Specialized technical expertise.
  • Other distinct personal abilities which create economic value to a business.

When an individual is deemed to have a significant amount of personal goodwill, he or she, as opposed to their business, is the creator and owner of certain valuable intangible assets, primarily customer and supplier relationships. As we will see below, personal goodwill is a concept recognized by various courts in the U.S.

There are three instances where the valuation of personal goodwill can help a business owner save money.

1. Business sale

Under certain conditions, when a corporation is sold, there are potential tax savings associated with allocating part of the purchase price to the selling shareholders’ personal goodwill.

A landmark tax case recognizing personal goodwill in a business sale is Martin Ice Cream.

In this 1998 case, the tax court decided that a corporation could not be taxed on payments made to its owner for his personal goodwill, resulting in significant tax savings:

“This Court has long recognized that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. Those personal assets are entirely distinct from the intangible corporate asset of corporate goodwill.” (Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998).

2. Gift/estate tax

In more recent years, personal goodwill has been quantified in business valuations for gift and estate tax purposes. Two recent tax court decisions discuss personal goodwill in the context of such business transfers: Bross Trucking, Inc. and Estate of Franklin Z. Adell.

In Bross Trucking, the tax court found that Bross’ personal goodwill was not transferred to the business, so Bross Trucking had no goodwill to gift, as a result, no gift tax was payable. In Estate of Adell, an economic charge of $8 to $12 million dollars was deducted from the value of the business for the personal goodwill of Kevin Adell, the decedent’s son, thus reducing the taxable estate amount. Both decisions resulted in significant tax savings for the taxpayers because of the existence and valuation of personal goodwill.

3. Marital dissolution

Business valuations for divorce purposes often need to separate personal goodwill from the rest of the business value because in many states, including Oregon, personal goodwill is not considered a marital asset. When one of the spouses has significant personal goodwill, the value of the business for purposes of marital dissolution will be reduced by that amount.

How is personal goodwill valued?

To be used as a savings tool, personal goodwill must be quantified. As mentioned above, not all businesses have goodwill. Similarly, not all business owners have personal goodwill. The existence and valuation of personal goodwill is very fact specific, and there are no rules regarding either.

Because personal goodwill is a concept that originated in case law, business appraisers consider the guidance in court cases when valuing personal goodwill.

One case, Lopez v. Lopez suggests several factors that should be considered in the valuation of personal goodwill with respect to professional practices:

  • The age and health of the individual.
  • The individual’s demonstrated earning power.
  • The individual’s reputation in the community for judgment, skill, and knowledge.
  • The individual’s comparative professional success.
  • The nature and duration of the professional’s practice as a sole proprietor or as a contributing member of a partnership or professional corporation.

Another case, Martin Ice Cream, provides guidance in identifying personal goodwill apart from corporate goodwill. The valuation analyst may ask the following questions to assess the existence of personal goodwill:

  • Do personal relationships exist between customers or suppliers and the owner/manager of the business?
  • Do these relationships (customer or supplier) persist in the absence of formal contractual obligations?
  • Does the owner/manager’s personal reputation and/or perception in the industry provide an intangible benefit to his business?
  • Are the practices of the owner/manager innovative or distinguishable in his or her industry, such that the owner/manager is regarded as having added value to that particular industry?
  • With respect to the above factors, is the owner/manager currently under any employment agreement or covenant not to compete with the business?

Conclusion

Personal goodwill may provide savings to business owners in the context of business sales and other ownership transfers such as gifts, estate transfers, and divorces. Business owners need to carefully work with their attorneys, tax advisers, and valuation professionals to achieve such cost savings.

Alina Niculita, CFA, is director of valuation services at Morones Analytics and specializes in business appraisal and business appraisal review.

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