Martin Ice Cream and the sale of personal goodwill

One of the roadblocks that commonly arises in structuring a business sale has to do with the competing tax consequences for the buyer and seller. From a tax standpoint, what is good for the seller is often bad for the buyer, and vice versa.

However, one important tax strategy for sellers generally has no impact on buyers: the allocation of company assets as “personal goodwill” of the company’s owner or executives. In this strategy, the individual’s personal reputation, expertise and relationships are segregated from the assets of the company being sold. The goodwill that otherwise would be attributed to the company is shifted to the owner/executive.

“The presence of personal goodwill can provide tax-efficient opportunities in merger-and-acquisition transactions by lowering corporate-level tax upon a sale or transfer of goodwill,” notes a Tax Adviser article, Personal Goodwill: Alive and Well Indeed. “Further, the gain on a sale of personal goodwill is generally considered capital gain and receives a preferential capital gains tax rate (assuming the goodwill has been held by the taxpayer for more than 12 months), as opposed to the higher ordinary income tax rate for the receipt of compensation.”

“Goodwill” is a form of (and is often used as a catch-all term for) “intangible assets” that represent the excess market value of a business beyond that of its tangible assets.

Under IRC § 197, the buyer of a business is entitled to deduct the amount paid in connection with goodwill (whether it is personal or corporate) over 15 years. The tax treatment to the buyer would be the same if the buyer purchased corporate or personal goodwill or if the buyer made covenant-not-to-compete payments to the seller in connection with the acquisition of a trade or business. Each such asset is considered a “Section 197 intangible.”

Section 197 intangibles also include going concern value, workforce in place, information-based intangibles (including customer-related information such as customer lists and patient or client files), expertise, customer-based intangibles, supplier-based intangibles, licenses, permits, covenants not to compete, franchises, trademarks and trade names.

It is important to note that not all goodwill is personal goodwill. There are valid situations in which the goodwill has a stronger connection to the company itself than to the owner, and it is important for the parties to recognize that distinction.

Lynton Kotzin, CPA, a business valuation partner at J.S. Held in Phoenix, notes that personal goodwill “attaches to a particular individual rather than to the business that the individual owns, while enterprise goodwill is derived from characteristics specific to a particular business, regardless of who owns or operates it.”

Where both types of goodwill are present, they should be allocated by agreement between the buyer and seller.

“There will be evidence of various elements of both personal and enterprise goodwill,” Kotzin continues. “A valuation analyst can consider many objective factors in making the allocation.”

The two types of goodwill are also differentiated by the way in which they are transferred, notes B.J. Kang, J.D., CPA.

“While corporate goodwill can be transferred through a typical asset transfer, a holder of personal goodwill must sign some form of a covenant not to compete,” Kang writes. “These restrictive covenants can take the form of a traditional covenant not to compete or even employment agreements, but must clearly transfer the intangible assets of the individual to either their employer or any potential buyer. Absent any such agreement, the personal goodwill of an individual remains the property of the individual, and can be used or disposed of however that individual sees fit.”

As was noted above, the determination of goodwill as “personal” or “enterprise” can have significant tax impacts on the seller. Consider the following example.

The subject company is being sold for $10 million. If the tangible assets are worth $8 million, the remaining $2 million would normally be classified as goodwill. If that goodwill is assigned to a C corporation, it generally will be taxed at the 21% rate and then taxed again when the proceeds are distributed to the shareholders.

If, on the other hand, it can be shown that the goodwill is attributable not to the corporation but to the owner/executive personally, then the $2 million would be paid directly to him and taxed as long-term capital gain (not as ordinary income). That keeps the proceeds out of reach of the subject company’s creditors if there are any. Finally, as was mentioned above, the tax treatment to the buyer is the same regardless of whether the owner/executive recognizes long-term capital gain from the sale of personal goodwill or ordinary income for a non-compete payment.

Also, for some taxpayers, creating personal goodwill helps minimize corporate income tax when the corporation liquidates, i.e., converts to an LLC that is taxable either as a partnership or as a disregarded single-member entity. The use of this technique can also minimize potential future built-in gain taxes if the corporation desires to make a subchapter S election.

The purposeful creation of personal good will first gained notoriety a decade ago in what has become a famous U.S. Tax Court case, Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998). In that decision, the Tax Court reaffirmed that, when a corporation has no employment contract with an employee (in this case, the owner), the employee’s personal relationships are not corporate assets.

Here are the particulars:

Arnold Strassberg and his son, Martin, owned all of the stock of Martin Ice Cream Co., an ice cream distributor. Before going into business with his son, Arnold had worked for more than a decade in his own wholesale ice cream distribution business, where he developed strong business relationships with the managers and owners of a number of supermarket chains. Shortly after launching Martin Ice Cream, Arnold was approached by the founder of Häagen-Dazs, who wanted Arnold to introduce that company’s ice cream to supermarkets. On a handshake agreement (which was never reduced to writing), Arnold quickly established distribution relationships with four chains.

In the mid-1980s, Pillsbury acquired Häagen-Dazs and approached Arnold about acquiring his relationships with the supermarkets so that Pillsbury could sell Häagen-Dazs products to them directly. Pillsbury was willing to pay for Arnold's connections but had no interest in a relationship with Martin Ice Cream or in acquiring any of its physical assets.

Ultimately, Arnold decided to sell his relationships to Pillsbury. Then:

• Arnold created a new corporation, Strassberg Ice Cream Distributors, as a subsidiary of Martin Ice Cream.
• All of the supermarket relationships of Martin Ice Cream Co. were transferred to Strassberg Ice Cream Distributors and held as the subsidiary’s only assets.
• Martin Ice Cream conveyed all of the subsidiary’s stock to Arnold in exchange for his interest in Martin Ice Cream.
• Strassberg Ice Cream Distributors then sold the relationship assets to Pillsbury for $1.4 million.
• As part of the sale, Arnold signed a bill of sale and an assignment of rights, and both Arnold and Martin signed non-compete agreements with Pillsbury.

Disagreement between the Strassbergs and the IRS over how the proceeds of the sale should be taxed ultimately led the parties to court. In its ruling in the Martin Ice Cream case, the Tax Court attributed the $1.4 million purchase value primarily to two assets:

• Arnold’s personal relationship with the supermarkets, and
• Arnold’s handshake agreement with the founder of Häagen-Dazs.

It is recognized in Martin Ice Cream that personal goodwill may be unique and is present only if supported by particular facts. For example, the seller should not be subject to a contractual non-compete provision in favor of his former company. Further, the seller should not be subject to any non-solicitation provision that prohibits him from contacting and trying to sell to his former company’s customers, suppliers or service providers.

As was noted above and is discussed in greater detail by Thomas O. Wells and Daniel Lampert in a Florida Bar Journal article, Sale of Personal Goodwill: The Executive’s Parachute, personal goodwill should be transferred pursuant to an asset purchase agreement executed by the buyer and seller. The agreement should describe the personal goodwill being transferred and include representations by the selling individual as to ownership of such assets and that such assets do not exist separate and distinct for the selling corporation. The agreement should also include exhibits such as a bill of sale and an assignment of rights (as suggested in Martin Ice Cream). The buyer may want to include any non-compete provision within the asset purchase agreement to obtain a lengthier presumption of reasonability for the restrictive time period. The parties may then allocate the purchase price between assets comprising the personal goodwill and the covenant not to compete.

Benefits. As was stated earlier, the proceeds received by the seller from the sale of personal goodwill are subject to long-term capital gain treatment rather than as ordinary income. (The maximum federal income tax rate for long-term capital gains is 15%, versus 35% for ordinary income.) In addition, long-term capital gains can be offset by capital losses, whereas only $3,000 of capital losses may offset ordinary income each year.

In Martin Ice Cream, the seller signed a non-compete agreement; the existence of this non-compete agreement did not cause the seller’s sale of personal goodwill to be subject to taxation as ordinary income. The non-compete agreement was seen by the Tax Court as necessary by the buyer to protect its purchase of the seller’s personal goodwill.

A seller who has unique skills, a strong relationship with customers and an excellent industry reputation and is not bound by a covenant not-to-compete should consider structuring a transaction as a sale of personal goodwill. This structure provides a seller with a beneficial parachute because the payments are treated as long-term capital gain, not subject to equitable distribution and not subject to the claims of the employer’s creditors. This structure can also be used during the conversion of a corporation to an LLC or limited partnership taxable, respectively, as a disregarded entity or partnership for federal income tax purposes.

If structured properly, the seller receives significant benefits with no adverse tax consequences to the buyer.