Personal Goodwill

By Blake Hassan, JD, CPA, and John McGill, JD, CPA, MBA

The concept of personal goodwill has been used in dental practice transitions for years and is of particular importance to C corporations. When a C corporation sells assets, a corporate level tax may result (taxed at a federal rate of 35% in a professional service corporation). Upon distribution of the after tax proceeds to the doctor as a dividend, a second tax is imposed on the doctor’s personal return. A successful allocation of a portion of the sale price to personal goodwill and/or a covenant not to compete, both payable to the doctor individually, avoids the corporation level tax. Personal goodwill is taxable as capital gain (current top federal rate of 15%) and the covenant not to compete is taxed as ordinary income (current top federal rate of 35%). Accordingly, the selling doctor has an incentive to allocate as much as possible to personal goodwill.

There is an established precedent that personal goodwill can exist separate and apart from the corporation and can be sold (e.g., the often-cited Martin Ice Cream v. Commissioner, 110 T.C. 189 (1998) and Norwalk v. Commissioner, TC Memo 1998-279 (1998)). However, 2010 and 2011 brought two new cases with unfavorable rulings.

Howard v. U.S. (9th Cir. 2011) involved the sale of a dental practice operated through a C corporation created in 1980. At that time the sole shareholder, Dr. Howard, entered into an employment agreement with the corporation that included a covenant not to compete, applicable while Dr. Howard was a shareholder and for three years thereafter, and covered a 50-mile radius of Spokane, Wash. The purchase price was allocated as follows: $47,100 to corporate assets, $549,900 to personal goodwill, and $16,000 to a covenant not to compete. The IRS treated the goodwill as an asset of the corporation, which resulted in tax to both the corporation and the doctor, individually.

Kennedy v. Commissioner (TC Memo 2010-206, 9/22/10) involved an employee benefits consulting business operated as a C corporation. The sole shareholder, Mr. Kennedy, did not have an employment agreement or a covenant not to compete. The purchase price allocation included a nominal amount for corporate assets. The balance of the purchase price was allocated 75% to personal goodwill and 25% to a consulting agreement. Mr. Kennedy agreed to continue providing services for five years for minimal compensation. The IRS treated the amount allocated to personal goodwill as payment for services and/or noncompete, resulting in ordinary income tax instead of capital gains.

Following the outcome of these cases, several doctors concluded that personal goodwill could no longer exist with a C corporation. This is not the case, and failing to allocate a portion of the practice sale price to personal goodwill can result in significant and unnecessary tax costs associated with the sale of a dental practice.

The Howard case is consistent with prior law, the critical element being the preexisting covenant not to compete. Where there is no such covenant not to compete, the personal goodwill approach is still viable. Additionally, the Kennedy case does not represent a departure from the established precedent that personal goodwill can exist and be sold. Instead, the court was simply not convinced that personal goodwill was in fact being sold.

Accordingly, doctors should take the following steps to properly position themselves for a successful practice transition:

1. Any doctor with an employment agreement with his or her corporation containing noncompete or other restrictive covenant provisions should terminate the agreement, or amend it to remove those and any other provisions that imply that the corporation owns or controls the goodwill.
2. Throughout the negotiation phase, the seller should emphasize and attempt to document the value of his or her personal relationships with patients, staff, referring sources, etc., document an intended allocation to personal goodwill, and support the allocation with an independent appraisal, if possible.
3. The transaction documents should require steps to convey the personal goodwill value to the buyer (e.g., letters to patients and referring sources introducing and endorsing the buyer, personal introductions, and more).
4. A reasonable amount of the sales price should be allocated to the seller’s post-sale noncompete.
5. A short transition period without compensation to the seller to assist in the transition process is acceptable. However, any extended period of consulting services by the seller, and any clinical work should not be without reasonable compensation.

Blake Hassan provides practice buy-in/buy-out and other legal services through McGill and Hassan, P.A, Attorneys at Law, an affiliate of the McGill & Hill Group, a one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment advisory services. John McGill provides tax and business planning exclusively for the dental profession and publishes the McGill Advisory newsletter through John K. McGill & Company, Inc., a member of the McGill & Hill Group, LLC. For more information, visit www.mcgillhillgroup.com or call (877) 306-9780.