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introduction
This discussion focuses primarily on the valuation
of the closely held (or family-owned) company.
Primarily, but not exclusively, this discussion focus-
es on the valuation of a closely held C corporation
that is managed by its shareholder/employees.
In particular, this discussion focuses on the
question of how much of the total business enter-
prise value relates to the personal goodwill of the
company shareholder/employees.
There are numerous gift tax, estate tax,
generation-skipping transfer tax, and income tax
reasons why valuation analysts may be asked
to allocate the subject business enterprise total
intangible asset value between (1) the company's
entity goodwill and (2) the individual shareholder/
employee's personal goodwill.
This discussion is informed by the recent U.S.
Tax Court decision in Bross Trucking, Inc., et al.
v. Commissioner of Internal Revenue1 (the "Bross
Trucking decision").
There are several instances when it is important
for a closely held corporation (and for its owners) to
distinguish between:
1. the personal goodwill (owned by the indi-
vidual shareholder/employees) and
2. the entity goodwill (owned by the company
itself).
The first instance typically relates to the formation
of the closely held company. In many closely held
corporation formations, individual shareholder/
employees transfer their personal goodwill to the
newly formed corporation in exchange for newly
issued shares of the corporation stock.
Those transfers of personal goodwill may qualify
as a tax-deferred exchange (of personal goodwill for
corporation stock) under Internal Revenue Code
Section 351.
The alternative tax treatment (when personal
goodwill is not transferred) is to treat the issuance of
the corporation stock as taxable equity-based com-
pensation for the shareholder/employee's "sweat
equity" in the newly formed company.
The second instance may involve the conversion
of the closely held C corporation to a closely held
S corporation. In such a tax status conversion
Estate Planning Insights
Distinguishing Personal Goodwill from
Entity Goodwill in the Valuation of a
Closely Held Corporation
Robert F. Reilly, CPA
The valuation of a closely held corporation often has gift tax, estate tax, and
generation-skipping transfer tax implications. In addition, the valuation of a closely held
corporation often has income tax implications. In these tax-related instances, it is often
important for the business owners (and for their professional advisers) to allocate the
total enterprise value (or the total transaction consideration) between (1) the company-
owned entity goodwill and (2) the individual shareholder/employee-owned personal
goodwill. This discussion summarizes the valuation analyst considerations with regard to
the elements of, the separability of, and the documentation of a shareholder/employee's
personal goodwill.
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INSIGHTS WINTER 2016 55
transaction, the C corporation assets are valued on
the date of the tax status conversion.
If the S corporation is then sold during the term
of the Section 1374 built-in gain recognition period,
that corporation would have to pay tax on any gain
(i.e., the amount of the sale price over the tax basis
of the company assets).
However, any assets that are owned outside
of the C corporation (such as the shareholder/
employee's personal goodwill) would not be part of
the corporation's tax status conversion.
Therefore, the amount of any personal goodwill
that would be transferred along with the sale of the
(now) S corporation would not be subject to the
Section 1374 built-in gain recognition. Of course,
the individual shareholder/employee would still
recognize one level of tax on the sale of his or her
personal goodwill.
The third instance is the most common instance,
and it relates to the sale (structured as an asset sale)
of the closely held corporation. In such a sale, the
business sale transaction would be structured as
(and the deal documents should reflect) two sepa-
rate transfers:
1. The sale of the closely held corporation
assets
2. The sale of the shareholder/employee's
personal goodwill
The sale of the assets of the C corporation will
likely be subject to two levels of taxation: (1) once
at the corporation level for the sale of any appreci-
ated (sale price in excess of tax basis) assets and (2)
again at the shareholder level related to the distribu-
tion of the after-corporate-tax sale proceeds to the
individual shareholders.
However, the shareholder's sale of any personal
goodwill should be subject to only one level of taxa-
tion. This is because the individual shareholder is
selling his or her personal goodwill directly to the
business acquirer.
In addition, any gain on the sale of the share-
holder/employee's personal goodwill would typically
be considered a capital gain, subject to preferential
capital gains tax treatment. The capital gain treat-
ment assumes that the personal goodwill was owned
by the individual shareholder/employee for more
than 12 months.
The fourth instance relates to other transfers of
the closely held corporation stock or of the personal
goodwill.
Such transfers could occur in a gift tax, estate
tax, or generation-skipping transfer tax situation.
Such situations depend on:
1. which assets (personal goodwill, entity
goodwill, or other assets) were transferred,
2. who transferred and who received the trans-
ferred assets, and
3. the valuation of the transferred assets.
The Bross Trucking decision relates to such a
set of circumstances. The Internal Revenue Service
(the "Service") claimed that the owner of Bross
Trucking Company, Inc. ("Bross Trucking") made
a gift of transferred goodwill to a new company
formed by his three sons.
Based on the Tax Court's judicial guidance pro-
vided in the Bross Trucking decision, this discus-
sion considers:
1. the elements that demonstrate the existence
of an individual shareholder/employee's
personal goodwill,
2. the factors that differentiate the existence
(and transfer) of personal goodwill from the
existence (and transfer) of entity goodwill,
and
3. the components of the transaction (and of
the deal documentation) that indicate the
transfer of personal goodwill as part of the
overall closely held business sale transac-
tion.
thE Bross Trucking dEcision
In the Bross Trucking decision, the Tax Court con-
cluded that a trucking company owned by Chester
Bross ("Chester") did not distribute goodwill to
Chester who, in turn, did not transfer the goodwill
to a newly formed trucking company owned by
Chester's three sons.
The name of the sons' trucking company was
LWK Trucking Co., Inc. (LWK).
Therefore, the Tax Court determined that
Chester owed no gift tax with regard to any transfers
to LWK or to his three sons.
In the Bross Trucking decision, Chester owned
a road construction company. Chester also orga-
nized several other companies to provide ser-
vices and equipment to his construction company.
Chester was knowledgeable about the construc-
tion industry, and he had developed important
relationships with government entities and other
customers.
Chester created Bross Trucking, a wholly owned
company, to haul construction-related materials
and equipment for road construction projects. It
is important to note that Chester did not have an
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employment contract withand he never signed a
noncompete agreement withBross Trucking.
About 90 to 95 percent of the Bross Trucking
primary customers were companies owned by Bross
family members. However, Bross Trucking did not
have any formal written service agreements with
any of its customers.
After facing a series of audits and investigations,
Bross Trucking received an unsatisfactory safety
rating. Bross Trucking had experienced extensive
investigations from both:
1. the United
States Department
of
Transportation and
2. the Missouri Division of Motor Carrier and
Railroad Safety.
Bross Trucking was in jeopardy because of
heightened scrutiny from both federal and state
safety inspectors. The company faced the possibility
of having its hauling authority revoked.
In response to this negative attention and a pos-
sible company shutdown, Bross Trucking ceased
its ongoing business operations. Nonetheless, Bross
Trucking remained as a legal entity to address any
potential regulatory claims and obligations.
To ensure continued trucking services to the
Bross family businesses, Chester's three sons cre-
ated LWK. Chester did not own any interest in LWK.
And, Chester was not involved in managing LWK.
No assets were transferred from Bross Trucking
to LWK. LWK met all regulatory requirements on its
own. However, about 50 percent of the LWK employ-
ees previously worked for Bross Trucking.
LWK leased its equipment (primarily its trucks)
from the same family-owned leasing business as
Bross Trucking had. While LWK operated under a
similar business model as Bross Trucking, it expand-
ed into several other service lines.
Initially, some of the LWK trucks still displayed
the Bross Trucking logos. However, these Bross
Trucking logos attracted heightened scrutiny from
the safety inspectors that had investigated Bross
Trucking. Therefore, LWK used magnetic signs to
cover up the Bross Trucking logos until it could
afford to have the trucks repainted.
Chester and his wife did not report any gifts
for the year in which LWK began operations. The
Service issued a notice of deficiency to Mr. and Mrs.
Bross, determining:
1. a distribution of corporate intangible assets
to Chester and
2. a subsequent transfer of these intangible
assets to the Bross sons.
The Service's notice of deficiency described the
allegedly transferred intangible assets as the follow-
ing intangible "attributes":
1. Goodwill
2. Established revenue stream
3. Developed customer base
4. Transparency of the continuing operations
between entities
5. Established workforce including indepen-
dent contractors
6. Continuing supplier relationships
The Service's notice of deficiency was unclear
as to (1) whether each intangible "attribute" was
supposed to be a separate intangible asset or (2)
whether the "attributes" were supposed to be aggre-
gated into goodwill as a whole.
The principal issues presented before the Tax
Court in this matter were whether:
1. any appreciated intangible assets were dis-
tributed by Bross Trucking to Chester and
2. Chester made a gift of these distributed
intangible assets to his sons.
The Tax Court initially determined that the
intangible asset that was being transferred was good-
will. Goodwill is often defined as the expectation of
continued patronage. The competitive advantage
that constitutes goodwill may be represented by a
number of property rights or legal interests.
Accordingly, the Tax Court concluded that the
intangible "attributes" listed in the notice of defi-
ciency were separate interests or legal rights that
the Service alleged to have made up the Bross
Trucking goodwill.
After reaching this initial conclusion, the Tax
Court concluded that there was no corporate distri-
bution of goodwill from Bross Trucking to Chester.
The Tax Court reached this conclusion because
it determined that a business can only distribute
corporate assets, not assets that it does not own.
Specifically, a corporation cannot distribute intan-
gible assets owned individually by its sharehold-
ersin this case, Chester.
The Tax Court cited three reasons for this deter-
mination.
First, the Bross Trucking goodwill was limited to
a workforce in place. At the time, Bross Trucking
had lost most of its goodwill and reputation with its
customers because of:
1.
its unsatisfactory safety rating,
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INSIGHTS WINTER 2016 57
2. the heightened regulatory scrutiny from
safety inspectors, and
3. the possibility of a shutdown of business
operations.
The Tax Court classified these three circum-
stances as "the antithesis of goodwill." This antith-
esis of goodwill was demonstrated by the LWK need
to hide the Bross Trucking name and logo on the
LWK trucks.
At the time of the alleged transfer of goodwill,
Bross Trucking could not expect any continued
patronage. This was because its customers did not
trust it and did not want to continue doing business
with it.
The Tax Court recognized that Bross Trucking
employed several mechanics and administrative
staff. Bross Trucking may have used this assembled
workforce in the corporation and transferred that
assembled workforce to Chester.
However, the Tax Court indicated that the record
was unclear as to whether its independent contrac-
tor drivers could be counted as part of the Bross
Trucking assembled workforce.
Second, nearly all the goodwill used by Bross
Trucking was part of Chester's personal assets.
The Bross Trucking established revenue stream, its
developed customer base, and the "transparency
of the continuing operations" were all a result of
Chester's work in the road construction industry
and the personal relationships that he had devel-
oped.
The Tax Court concluded that a company does
not have any entity goodwill when all of the goodwill
is attributable solely to an individual shareholder/
employee's personal ability.
Third, Chester did not transfer his personal
goodwill to Bross Trucking partly because he did
not have an employment contract or a noncompete
agreement with the company. The Tax Court noted
that an employer has not received personal goodwill
from an employee where that employer does not
have a right to the employee's future services.
Therefore, Chester's personal goodwill remained
a personal asset, separate from the Bross Trucking
corporate assets.
The Tax Court concluded that because Chester
did not gift the intangible assets to his three sons,
he was not required to file a gift tax return. Because
Bross Trucking did not distribute intangible assets
to Chester, the Tax Court determined that any
remaining issues were moot.
The Tax Court also determined that Bross
Trucking did not transfer intangible assets. This is
because the intangible assets
that the Service alleged to
be transferred, Bross Trucking
never owned. Rather, these
intangible assets were person-
ally owned by Chester.
thE ElEmEnts oF
thE pErsonal
Goodwill
The primary requirement
related to personal goodwill
is for the business owner to
establish that his or her per-
sonal goodwill exists sepa-
rate from any closely held
corporation's entity goodwill.
Personal goodwill is property with a value depen-
dent solely on the personal characteristics of the
individual business owner.
Although very fact specific, these personal char-
acteristics can include the personal relationships,
ability, personality, and reputation of the individual
shareholder where the company does not have a
right by contract or otherwise to that individual's
future services.
Judicial guidance with regard to this particular
element of personal goodwill is provided in several
Tax Court decisions, including Martin Ice Cream
Co.,2 Norwalk,3 and Schilbach.4
In the Bross Trucking decision, Chester, a suc-
cessful construction businessman, had established
close, personal relationships with his primary cus-
tomers. Additionally, Chester was extremely knowl-
edgeable about the trucking industry because of his
many years of experience. To that end, customers
sought these personal traits through their relation-
ships with Chester, which led directly to business
for Bross Trucking.
As a result, the Tax Court concluded that
Chester's personal goodwill existed through these
relationships.
The Tax Court noted that the facts in the Bross
Trucking case were analogous to the facts in the
Martin Ice Cream case. In the Martin Ice Cream
decision, the corporation's success was attributed to
the individual shareholder's personal relationships
with his retail customers. These personal relation-
ships constituted an intangible asset used to establish
a revenue stream and to develop a customer base.
However, because these personal relationships
and the corresponding intangible assetswere
"The primary
requirement relat-
ed to personal
goodwill is for the
business owner to
establish that his or
her personal good-
will exists separate
from any closely
held corporation's
entity goodwill."
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never transferred to the corporation, the Tax Court
held that the intangible assets were the shareholder's
personal property.
Similarly, the Tax Court in the Bross Trucking
decision held that any existing goodwill from Chester's
personal relationships was his personal goodwill.
One factor in the Bross Trucking decision sup-
porting the position that it was Chester's personal
goodwill was that Bross Trucking clearly lacked its
own entity goodwill. Bross Trucking had an impend-
ing suspension from various regulatory infractions,
causing it to face bankruptcy. Further, the impending
suspension caused customer uncertainty and busi-
ness interruptions that impaired the business.
Unlike many situations involving claims of per-
sonal goodwill, the nonexistence of entity goodwill
was clear in the Bross Trucking decision.
In addition, the Tax Court distinguished the Bross
Trucking decision from the Solomon decision.5
In Solomon, the corporation's success occurred
because of the company's products and not because
of any relationships that the shareholders formed.
In the Solomon decision, the taxpayers failed to
convince the Tax Court that their personal abilities
in developing an iron ore processing business were
of any value.
The Tax Court concluded that the acquiring party
did not need the goodwill of Solomon Colors
or any of its key employees to succeed; in
fact, after the acquisition [the acquiring
party] continued to do business under its
own name, not under the name of Solomon
Colors.
Also, in the Solomon decision, the selling share-
holders effectively ended their involvement in the
business following the company sale, further indicat-
ing that their personal abilities were dispensable.
thE sEparaBility oF thE
pErsonal Goodwill
A second requirement for the existence of personal
goodwill is that the individual shareholder pos-
sess the right to sell his or her goodwill. To avoid
corporate-level income tax, the personal goodwill
must be the shareholder's individual asset. And, the
shareholder cannot have previously transferred that
personal goodwill to the corporation.
Tax Court precedent establishes that personal
goodwill is transferred to a corporation when the
individual shareholder/employee cannot personally
benefit from it without the employer corporation.
This issue is discussed in such Tax Court decisions
as Martin Ice Cream Co.6 Norwalk,7 H&M, Inc.,8
and Bross Trucking, Inc.9
Personal goodwill is often transferred through
shareholder or employment agreements, such as an
employment contract or a noncompete agreement.
In general, once such an agreement is in existence,
any current goodwill (or goodwill created thereafter)
will likely belong to the corporation.
In the Bross Trucking decision, Chester never
entered into an employment contract or a noncom-
pete agreement with the company. Chester was free
to leave the company and take his relationships with
him if he decided to compete against the business.
The Tax Court stated "[a]n employer has not
received personal goodwill from an employee where
an employer does not have a right, by contract or
otherwise, to the future services of the employee."
As a result, the lack of such agreements allowed
the Tax Court to conclude that Chester did not trans-
fer his personal goodwill to the corporate entity.
The favorable facts in the Bross Trucking deci-
sion may be contrasted with the facts in Howard.10
In that Appeals Court decision, Larry Howard, a
practicing dentist, incorporated his sole proprietor-
ship and entered into an employment agreement and
a noncompetition agreement with the corporation.
Later, Larry decided to sell his practice.
Larry argued that the sale included the sale of
his personal goodwill. The Service, however, rechar-
acterized the payment that Larry received. Larry
claimed the payment to be for the sale of personal
goodwill. The Service classified the payment as a
dividend payment from the corporation.
The Ninth Circuit concluded that Larry's personal
goodwill did not exist separately from the corporate
assets. Specifically, the Appeals Court noted that,
although Larry possessed some personal goodwill
through his patient relationships, "the economic value
of those relationships did not belong to him, because
he had conveyed control of them to [his business]."
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INSIGHTS WINTER 2016 59
As a result, the Ninth Circuit upheld the Service's
recharacterization of the transaction payment as a
dividend.
thE documEntation oF thE
pErsonal Goodwill
While not an issue in the Bross Trucking decision, it
is noteworthy that certain formalities and documen-
tation will help support the taxpayer positions taken
with respect to personal goodwill. Personal goodwill
should be:
1. valued by an independent valuation analyst,
2. clearly identifiable in the purchase agree-
ments, and
3. agreed to by the acquiring party.
In the Kennedy decision,11 James Kennedy, the
sole shareholder of KCG International, sold his con-
sulting business corporation. Late in the negotiation
process, the transaction parties agreed that:
1. 25 percent of the purchase price should be
designated as a payment for consulting ser-
vices and
2. the remaining 75 percent should be des-
ignated as a payment for James' personal
goodwill.
To effectuate the sale of James' personal goodwill,
the parties entered into three separate agreements,
one of which was for the sale of James' personal
goodwill and customer lists. In a separate agreement,
James agreed to continue to service his former cli-
ents as an employee of the acquirer.
While the Tax Court found that James did own
personal goodwill, it held that the identification of
personal goodwill is not enough to conclude that
the personal goodwill had been sold. The Tax Court
stated that "[e]ven though a payment to a service
provider can be considered a payment for goodwill
in certain circumstances, we are convinced that the
payments to Kennedy were consideration for ser-
vices rather than goodwill."
The Tax Court went on to state that it found
it significant that there is a lack of eco-
nomic reality to the contractual allocation
of the payments to goodwill. In other cases,
the contractual allocation of a portion of a
payment to goodwill has been important in
determining that the payment was indeed
for goodwill. In those other cases, the con-
tractual allocation appeared to genuinely
reflect the relative value of the seller's cus-
tomer relationships compared to the value of
the seller's ongoing personal services.12
The Tax Court's decision was based on the lack
of an independent valuation or any other meaningful
attempt to allocate the transaction sales proceeds.
Accordingly, the Kennedy decision illustrates the
importance of formal documentation regarding the
value of personal goodwillwith an independent valu-
ation to support the contractual sale price allocation.
The Tax Court also looked to the actual language of
the purchase agreements in the Solomon decision. In
the Solomon decision, the taxpayers (i.e., father and
son shareholders) argued that the acquiring party pur-
chased the shareholders' personal goodwill. The tax-
payers argued that such personal goodwill represented
value generated from their customer relationships.
In its decision, the Tax Court concluded three
reasons why the taxpayers did not sell personal
goodwill.
First, the Tax Court concluded that nothing in the
transaction agreement between the parties referred
to the sale of personal goodwill or customer lists per-
sonally owned by the taxpayers.
Second, unlike the facts in the Martin Ice Cream
decision, the Tax Court concluded that the facts
did not support that the value of the business was
attributable to the taxpayers' personal attributes and
relationships.
Third, although the taxpayers entered into non-
compete agreements, the Tax Court concluded that
the lack of employment or consulting agreements
arguably demonstrated that the intent was not the
purchase of personal goodwill.
As a result of these three factors, the Tax Court
attributed the transaction payments to the taxpayers'
covenants not to compete in the Solomon decision.
summary and conclusion
Based on the above-described judicial guidance, it is
clear that the lack of supporting contractual docu-
mentation and the lack of an independent valuation
may damage an otherwise strong case for the sale of
personal goodwill.
In general, the sale of a C corporation through
an asset sale structure will result in two levels of
income tax:
1.
A taxable gain to the corporation
2. A taxable distribution to the shareholders
One strategy for closely held corporation share-
holders to avoid this double taxation involves the
assertion that a portion of the business sale relates to
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the sale of the personal goodwill of the shareholder/
employee. Therefore, a portion of the total purchase
consideration should only be taxed onceas a capi-
tal gain to the shareholder/employee directly.
The concept of personal goodwill is well-estab-
lished, dating back to the above-mentioned Tax
Court decision in Martin Ice Cream Co. The Martin
Ice Cream decision involved a father and son who
operated an ice cream distribution business through
a corporation.
The Tax Court concluded that the success of the
business depended entirely on the father, who had
personal relationships with supermarket owners and
an oral agreement with the founder of Hagen-Dazs
to distribute a line of super-premium ice cream to
supermarkets.
At no time did the father have an employment
agreement with Martin Ice Cream. Following the
purchase of Hagen-Dazs by Pillsbury, negotiations
between Martin Ice Cream and Hagen-Dazs ensued
for the acquisition of the Martin Ice Cream ice cream
distribution business.
The father and son disagreed on the future of the
business, and they decided to split the assets of the
corporation in what was meant to be a tax-free split-
off under Section 355.
The Tax Court concluded that the transaction
failed the requirements of Section 355. Therefore,
Martin Ice Cream was subject to tax on the distribu-
tion of appreciated property under Section 311.
In determining the income tax impact to Martin
Ice Cream, the Tax Court analyzed whether the
father had (1) transferred certain intangible assets
to the corporation or (2) retained these intangible
assets personally.
The Tax Court concluded that the success of the
business depended entirely on:
1. the father's relationships in the marketplace
and
2. the father's oral agreement with the founder
of Hagen-Dazs.
The Tax Court concluded that these assets repre-
sented personal intangible assets.
The Tax Court concluded that these assets could
not be owned by Martin Ice Cream. This was because
the father never entered into a covenant not to com-
pete or any other agreement with Martin Ice Cream
that would result in the transfer of rights in those
assets to Martin Ice Cream.
The recent Tax Court decision in Bross Trucking
illustrates that, with the right set of facts, the sale of
personal goodwill, as an asset separate from corpo-
rate-owned goodwill, should withstand a challenge
from the Service.
For an individual shareholder/employee to sell his
or her personal goodwill, that intangible asset must:
1. meet the definition of goodwill from a tax
perspective and
2. be owned by the individual outside of the
legal business entity.
The main issue in the Bross Trucking decision
was the Service's contention that Bross Trucking
distributed appreciated intangible assets (including
goodwill) to its sole shareholder, Chester Bross.
The Service alleged that Chester then transferred
those intangible assets to a newly created trucking
entity that his three sons owned.
In holding for Chester, the Tax Court concluded
the following:
1. Bross Trucking had no corporate goodwill at
the time of the alleged distribution.
2. Chester's personal goodwill constituted all of
the Bross Trucking goodwill.
3. Chester did not transfer any of this personal
goodwill to the company that he had owned
and operated.
Notes:
1. Bross Trucking, Inc. v. Commissioner, T.C. Memo
2014-107 (June 5, 2014).
2. Martin Ice Cream Company v. Commissioner, 110
T.C. 189 (1998).
3. Norwalk v. Commissioner, T.C. Memo 1998-279
(July 30, 1998).
4. Christhart S. and June Schilbach v. Commissioner,
T.C. Memo 1991-556 (Nov. 6, 1991).
5. Solomon v. Commissioner, T.C. Memo 2008-102
(Apr. 16, 2008).
6. Martin Ice Cream Co., 110 T.C. 198.
7. Norwalk, T.C. Memo. 1998-279.
8. H&M, Inc. v. Commissioner, T.C. Memo 2012-290
(Oct. 15, 2012).
9. Bross Trucking, Inc., T.C. Memo 2014-107.
10. Howard v. U.S., 448 Fed.Appx. 752 (9th Cir.
2011).
11. Kennedy v. Commissioner, T.C. Memo 2010-206
(Sept. 22, 2010).
12. Id., at *23.
Robert F. Reilly, CPA, is a managing
director of the firm and is resident in
the Chicago practice office. Robert can
be reached at (773) 399-4318 or at
rfreilly@willamette.com.