When a professional corporation sells its assets or liquidates, one important tax issue is whether the corporation or the shareholder-employees own any appreciated professional goodwill (with a fair market value in excess of tax basis).
For tax purposes, goodwill is an intangible asset. It represents the value of a trade or business based on expected continued customer patronage due to its name, reputation and similar factors.
Such goodwill often does not appear on the corporate balance sheet, because it was developed by the corporation or by its shareholder-employees without any historical cost assigned to it for either financial accounting or tax accounting purposes.
When valuable professional goodwill does not show up on the corporate balance sheet, it can often be overlooked when evaluating the tax impact of liquidating the corporation. That could be a big mistake.
Why It Matters
When a professional C corporation is determined to own valuable goodwill that has little or no tax basis, selling the corporation’s assets (including the goodwill) or liquidating the corporation can trigger double taxation. On the other hand, if the shareholder-employees are determined to own the goodwill, the value of that goodwill will not be exposed to double taxation. The following two examples illustrate the point.
Example 1: Professional C Corporation Owns the Goodwill
Let’s say you and your business partner are equal shareholders of a professional C corporation we’ll call ABC Corp. After some serious disagreements about the future of the business, you and your partner decide to liquidate the corporation and go your separate ways. Assume you each have basis of $50,000 in your ABC Corp shares, which you have held for many years.
Immediately before the liquidation, ABC Corp owned two assets:
- Cash of $500,000.
- Goodwill with fair market value of $1 million and tax basis of zero.
Upon liquidation, ABC Corp is deemed to sell its assets for FMV. Therefore, the corporation must recognize a $1 million corporate-level taxable gain on the deemed sale of the appreciated professional goodwill. Assume the corporate-level federal income tax hit is $340,000 (34 percent of the $1 million gain. In this analysis, we will ignore any state taxes).
ABC Corp pays the $340,000 tax bill and distributes the remaining cash of $160,000 ($500,000 minus $340,000 lost to taxes) and the goodwill worth $1 million to the you and your partner in a complete liquidation.
You each receive liquidation proceeds of $580,000 ($80,000 of cash plus $500,000 of goodwill) in exchange for turning in your stock. These exchanges are treated as garden-variety stock sales. Therefore, you and your partner must each recognize a $530,000 long-term capital gain (stock sale proceeds of $580,000 minus $50,000 tax basis in the shares). If the liquidation occurs in 2014, each shareholder could owe the IRS up to $106,000 (20 percent times $530,000) for a combined total of $212,000. Plus, the entire gain could potentially get hit the 3.8 percent Medicare surtax. If so, that would add another $40,280 to the tax bill (3.8 percent times $530,000 times 2).
The overall federal income tax bill from liquidating ABC Corp could be up to $592,280 ($340,000 at the corporate level plus $212,000 plus $42,280 at the shareholder level).
Example 2: Shareholder-Employees Own the Goodwill
Same basic facts as in Example 1, except this time assume that it is determined that you and your business partner, rather than ABC Corp, own the professional goodwill.
There is no corporate-level tax liability from liquidating ABC Corp because it doesn’t own any appreciated assets.
You and your partner each receive cash liquidation proceeds of $250,000 in exchange for turning in your stock. These exchanges are treated as regular stock sales. Therefore, you and your partner must each recognize a $200,000 long-term capital gain (stock sale proceeds of $250,000 minus $50,000 tax basis in the shares). If the liquidation occurs in 2014, each shareholder could owe the IRS up to $40,000 (20 percent times $200,000) for a combined total of $80,000. You could also owe up to a combined $15,200 for the 3.8 percent Medicare surtax (3.8 percent times $200,000 times 2).
Therefore, the overall maximum federal income tax cost of liquidating ABC Corp would be $95,200 ($80,000 plus $15,200). Compare this to the $592,280 tax cost in Example 1 where the corporation was determined to own the professional goodwill. The entire tax difference is solely due to the difference in who owns the professional goodwill.
Bottom Line: As you can see, corporate ownership of professional goodwill is detrimental, while shareholder ownership of professional goodwill is beneficial.
Unfavorable Court Decision on Goodwill Ownership
One court decision concluded that a professional dentistry corporation, rather than its sole shareholder, Larry Howard, was the owner of professional goodwill worth $550,000 when the practice was sold.
Facts of the case: In 1980, Howard entered into an employment contract and noncompete agreement with his corporation. Under the noncompete agreement, Howard was precluded from having any affiliation with any competitive dental practice within 50 miles of the corporation’s practice. This restriction lasted for as long as Howard owned any of the corporation’s stock and for another three years after the date when he no longer owned any shares.
Under these facts, Howard could not leave and take the corporation’s patients with him. Therefore, the U.S. District Court ruled that the professional goodwill was owned by the corporation rather than by Howard himself. The District Court was not swayed by the fact that Howard could have single-handedly terminated the noncompete agreement any time before selling the practice, because he never actually took that step.
Similarly, the District Court was not swayed by the fact that the sale agreement stipulated that Howard owned the goodwill and that the buyer paid him directly for it. The District Court recharacterized the buyer’s payment for the goodwill as being made to the corporation, with the amount then distributed from the corporation to Howard. That resulted in double taxation on the value of the goodwill.
Finally, the court appeared to agree with the IRS position that the existence of the employment contract between Howard and the corporation indicated that the corporation, rather than Howard, was the income-earning entity. This factor apparently gave additional weight to the conclusion that the corporation owned any professional goodwill generated by Howard’s efforts. (Larry Howard v. U.S., DC WA 7/30/2010)
With Advance Planning, Look at Two Older Decisions
In situations where restrictive employment or noncompete agreements do not exist when a professional corporation’s assets are sold or the corporation is liquidated, two longstanding court decisions might be able to be cited to make the case that shareholder-employees, rather than the corporation, own the goodwill associated with the business. (Martin Ice Cream Company, 110 TC 189 (1998) and William Norwalk, Tax Court Memo 1998-279)
Strategy: To make a convincing argument that goodwill is owned by the shareholder-employees rather than the corporation, consider explicitly terminating any employment agreements and noncompete agreements as far in advance of the corporation’s sale of assets or liquidation as possible. Then, the Martin Ice Cream and William Norwalk decisions can be used to make the case that the shareholder-employees own the professional goodwill, with tax-saving results. Consult with your tax adviser and attorney about your situation.
McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.