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Treatment of Goodwill Upon the Sale of a Business

Asset of the Owner v. Asset of the Company

When determining the proper tax treatment of proceeds from the sale of a service company, it must be determined what amount, if any, may be allocated as payments attributable to personal goodwill. A key case in this determination is a Washington federal district court case titled Howard v. Commissioner.

In 1980, Larry E. Howard, D.D.S. incorporated his dental practice. Dr. Howard was the sole shareholder, officer and director of the corporation. In addition, in the same year, Dr. Howard entered into an employment agreement and covenant not to compete with the corporation. In 2002, Dr. Howard retired and negotiated the sale of his practice to a corporate buyer for approximately $613,000. As is often the case with medical and dental practices, the corporation had few "hard assets" to include in the sale; less than $50,000 in this case.

On Dr. Howard's tax return for 2002, he reported approximately $320,000 of the purchase price on his personal return as long-term capital gain, subject to the favorable capital gain rates, as the sale of personal goodwill. The IRS rejected this claim, asserted that the goodwill was a corporate asset and recharacterized the $320,000 as a dividend to Dr. Howard from the corporation, subject to ordinary income tax rates. The difference in the capital gains income tax rate and the rate taxed on dividends (taxed as ordinary income in 2002) resulted in a deficiency determination in excess of $60,000, plus penalties and interest. Dr. Howard thereafter paid the additional tax and sought a full refund.

The federal district court found in favor of the IRS and determined that prior cases have shown that in circumstances in which an employee is covered by a covenant not to compete, any goodwill generated from the employee's work is an asset of the employer. Further, because the covenant not to compete restricted Dr. Howard's ability to practice dentistry in a 50-mile radius, if the goodwill was Dr. Howard's personal asset, the asset would have had little value because it is unlikely his existing patients would travel such a long distance to receive his services.

In this case, the goodwill that made up a majority of the purchase price was therefore an asset of the corporation, subject to tax at the corporate level that could then be distributed to the shareholder as a dividend and subject to additional tax at the individual level.

Although the effects of this decision are less costly under current tax law which taxes dividends at preferential tax rates, double taxation still applies. When structuring employment relations between a professional service entity and its employee-owners, consideration should be given to the tax consequences upon the ultimate sale of the entity, including whether a covenant not to compete should exist between the entity and its owner.

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