Finally, a careful examination of existing employment contracts is necessary. A shareholder who is bound by the terms of a long-term employment contract with the company may be effectively prevented from competing with the company, even if that agreement does not contain non-compete obligations. This court has long recognized that a shareholder-employee`s personal relationship is not an asset of the company if the employee does not have an employment contract with the company. These personal assets are completely different from the intangible assets of goodwill. 7 To illustrate the problem of pre-existing non-compete agreements, look no further than the 2010 Howard District Court decision. 13 In this case, Dr. Larry Howard began practicing dentistry in 1972. In 1980, he established his practice as sole shareholder, officer and director of Larry E. Howard, DDS (Howard Corp.).
Also in 1980, Howard entered into an employment contract and an agreement not to compete with Howard Corp. The pact stipulated that as long as Howard held shares in the company and for three years thereafter, he would not operate in any capacity in a competing dental practice within 50 miles of the company`s location in Spokane, Washington, or hold a financial interest in it. All parties acknowledged that Howard, as the sole shareholder, director and officer of the Company, may modify or terminate the employment contract at any time and that he was bound by the terms of the agreement and agreed not to compete with Howard Corp. during the relevant period of this case. In 2002, Howard and Howard Corp. sold the firm to Dr. Brian Finn and his personal services company, Brian K. Finn, DDS, PS (Finn Corp.). In the asset purchase agreement, Howard received $549,900 for his personal goodwill and $16,000 for a commitment not to compete with Finn Corp. Howard Corp. received $47,100 for his fortune. As mentioned earlier, tax planning with respect to transactions involving the potential sale of personal goodwill depends on all the facts and circumstances of the business in question and various agreements between the seller (owner of the personal goodwill) and the company.
In particular, the seller may be prevented from selling his goodwill separately from the sale of the company`s assets if, for example, there is a non-compete obligation between the seller and the company at the time of the sale. Given the potential importance of the tax consequences for a seller who has valuable personal goodwill, it is advisable to review the relevant agreements, facts and documentation of this type of asset well before preparing a sale transaction. If a taxpayer concludes that the above criteria are met, assessing the fair value of personal goodwill is a crucial next step. However, it is not advisable to simply find a number out of nowhere and probably not to be durable. The prudent approach would be to engage an independent valuation panel of a third party to assess the value of the goodwill between the entity and the owner. Analysis in H&M represents a different perspective on personal goodwill. Typically, a dispute involving personal goodwill involves a taxpayer`s attempt to claim personal goodwill, while the IRS argues that goodwill is a business asset and therefore subject to double taxation. In h&M, the company was the taxpayer and the IRS wanted to convert the buyer`s deductible compensation payments into an additional purchase price that would be taxable to the company. However, the court ruled that the IRS did not provide enough evidence to determine that the company owned intangible assets, even though the compensation payments appeared excessive. This led the court to suspect that personal goodwill may exist, although personal goodwill was not addressed in the sales documents.
This claim contrasts with Muscat, in which the IRS and the court required documents of personal goodwill in negotiations or in the purchase agreement. Howard`s taxpayer, on the other hand, attempted to claim personal goodwill through the asset purchase agreement. Unfortunately for the taxpayer, the employment contract between the taxpayer and the company resembled the obligation not to participate in Martin Ice Cream, which in turn represents a relatively simple case for the IRS and the court to disregard goodwill as a personal asset. The concept of personal goodwill has been well established since martin ice cream co., 110 T.C. 189 (1998). In recent years, however, decisions have been made in Muscat, 554 F.3d 183 (1st Cir. 2009), Howard, No. 10-35768 (9th Cir. 8/29/11), and H&M, Inc., T.C. Memo. The years 2012-290 highlighted the importance of non-competitive restrictive covenants and asset purchase agreements to determine the existence of a personal business.
The example in Table 2 illustrates the potential tax savings for a structured transaction such as an asset sale where personal goodwill has been recognized […].
