Bluesky Assignment – Goodwill in the Sale of a Car Dealership

The IRS defines goodwill as “the value of a trade or business based on the expected continuing patronage of customers due to name, reputation, or any other factor.” IRS Publication 535: Business Expenses, Chapter 9, Cat. No. 15065Z.

The American Society of Appraisers defines goodwill as: “the intangible asset that arises as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.” And as “that intangible asset that arises as a result of elements such as name, reputation, customer loyalty, location, products and related factors not separately identified and quantified”.

However, goodwill can be separated into personal and commercial (business) goodwill. Unlike business goodwill, personal goodwill is the intrinsic value of the services of a specific, identifiable person to a business.

The distinction between personal and business goodwill is important to the extent that: (a) it saves taxes on the sale of businesses; and (b) divide property in a marriage.

In divorces, business goodwill is considered marital property and can be divided, while personal goodwill is the sole property of the individual. See: May v. May 589 SE2d 536 (W. Va. 2003) and Ledwith v. Ledwith, 2004 Will. application. LEXIS 488 (October 12, 2004).

When a C Corporation is sold, the company’s goodwill is taxed at the corporate rate (which could be as high as 35%) and then again as a dividend (another 5 – 15%) when it is distributed. Not including any state taxes that may be due, a profit of $3,000,000 could result in only $1,500,000 after taxes to a shareholder.

With a few exceptions, sales involving S corporations, partnerships, sole proprietorships, or other pass-through entities, Blue Sky is taxed only once as a capital asset. Note: C Corp. tax may also be incurred with an S Corp, if the S Corp. is not at least ten years old and does not have, for example, adequate built-in earnings. (Visit your accountant for the fine details).

In this article we are interested in auto dealer sales and seek to allocate a portion of the sale proceeds to personal goodwill because, as CPA Carl Woodward points out in The AutoCPA Group’s Spring 2006 “Headlights” issue: “For some dealerships, much of the total value of blue skies is due to this personal goodwill.”

The concept of separating goodwill from personal and business distinctions first appeared in the 1986 Nebraska case of Taylor v. Taylor 386 NW2d 851 and later spread to other states. See: Beasley v. Beasley, 518 A.2d 545 (Pa. Super. Ct. 1986); Hanson v. Hanson, 738 SW2d 429, 434 (Mo. 1987); Prahinski v. Prahinski, 75 Md App 113, 540 A2d 833 (1988); In Re Marriage of Talty 166 Ill 2d 232, 652 NE2d 330 (1995) and Martin Ice Cream Co v. Commissioner (110 TC 189 1998).

In 1998, Norwalk v. Commissioner TC memorandum 1998-279 held that personal goodwill arises from an intangible asset that is owned by the individual, not the corporation, and that personal goodwill could be paid to owners because the employment contracts of individuals expired when the corporation was sold.

(Some courts suggest that a seller enter into a non-compete agreement to protect the value of personal goodwill; however, if the personal goodwill portion of the purchase price was paid by a non-compete agreement, it would generate ordinary income rather than capital gains.

In addition, while Norwalk’s personal goodwill is not transferable without a non-compete agreement, in most states non-compete agreements are controlled by, among other things, “reasonableness” standards. And, in some states, enforceability is questionable.

Personal goodwill allocations have ranged from 10% to 90% of the total purchase price. In the sale of Tresco Dealerships, Inc., approximately 40% of the goodwill was allocated to the primary dealer as “personal goodwill,” resulting in a tax savings of approximately 27 cents on the dollar.

In one case, a medical practice had a total assessed value of approximately $600,000, with tangible assets of $165,000. The appraiser then allocated $165,000 to equipment and supplies, $35,000 to corporate goodwill, and $400,000 to the physician’s personal goodwill.

When structuring asset sales of “C” corporations, buyers generally agree to such allocations because it does not create adverse tax consequences for them.

The IRS evaluates personal goodwill in the context of the facts relating to each sale and the contracts, articles, minutes and so on of the selling corporation. Did the shareholder have, for example, a non-compete agreement with the company? Was there an employment contract that gave the corporation the benefit of the shareholder’s personal goodwill? Did the buyer think he was buying personal goodwill? Did the seller think he was selling it? (See: Private Letter Judgment 9621002).

This article is limited to discussing “personal goodwill” and is not intended to cover all of the tax-saving methods available at a dealership sale. Talk to your accountant and tax attorney about other options, such as installment sales and so on.