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Sale of Personal Goodwill-The Executive's Parachute

T he sale of personal good-will is desirable by anexecutive because a) pro-ceeds are generally tax-

able to the executive as long-termcapital gains and not as ordinaryincome; b) funds are transferreddirectly from the buyer to the execu-tive (and not through the executive'scompany subject to the company'screditors); and c) personal goodwillis not subject to equitable distribu-tion in connection with anexecutive's divorce. Under §197 ofthe Internal Revenue Code of 1986,as amended (the "Code"), the taxtreatment to the buyer is the sameregardless of whether the executiverecognizes long-term capital gainfrom the sale of personal goodwillor ordinary income for a noncompetepayment. Therefore, you have therare occurrence in federal incometax law in which there is no friction

between the buyer and executive.Finally, the creation of personalgoodwill for the executive-share-holder is critical to avoid a corporateincome tax under Code §311 or §336when a corporation attempts to con-vert to a limited liability companythat is taxable' either as a partner-ship or as a disregarded single-mem-ber entity. This article examines thesale of personal goodwill by defin-ing it, reviewing pretransactionmethods to create and transfer it,analyzing the benefits of selling it,and explaining the tax treatment tothe buyer in purchasing it.

Defining Personal Goodwill1)Definitionfor equitabledistri-

bution.TheFloridaSupremeCourt

by Thomas O. Wells and Daniel Lampert

An executive with

unique skills, a strong

relationship with its

customers, an excellent

industry reputation, andno covenant not-to-

compete should

consider structuring atransaction with an

acquirer as a sale of

personal goodwill.

in Thompson v.Thompson, 576 So.2d 267, 270 (1991), defined "per-sonal goodwill"as goodwill that de-pends on the continued presence ofa particular individual that is nota marketable asset distinct fromsuch individual. In Thompson, anattorney was divorcing his spouseand his spouse was claiming equi-table distribution in his law prac-tice. Equitable distribution entitleseach spouse to a presumption of 50percent equal ownership in allmarital assets pursuant to F.S.§61.075. The Florida SupremeCourt determined that the spousewas entitled to equitable distribu-tion in the "professional goodwill"of the law practice provided that

such goodwill must be a businessasset having value that is separateand distinct from the presence andreputation of the individual attor.ney. The court further stated thatany value that attaches to an en-tity solely as a result of personalgoodwill represents nothing morethan probable future earning ca-pacity that, although relevant indetermining alimony, is not aproper consideration in dividingmarital property in a dissolutionproceeding.

2) Definition for tax law. The taxdefinition of personal goodwill isderived primarily from two TaxCourt cases in 1998: Martin IceCream Co.v.Commissioner, 110T.C.189 (1998); and William Norwalk,Transferee, et al. v. Commissioner,TCM 1998-279 (1998).

In Martin Ice Cream, the TaxCourt held that the personal rela-tionships of a shareholder-em-ployee are not corporate assetswhen the employee has no employ-ment contract with the corporation.Arnold Strassberg was a major dis-tributor of ice cream in the north-east U.S. who had started distrib-utingice cream in 1960, taking overa business that his father hadstarted soon after World War II. In1974, the founder of Haagen-Dazs .

approached Arnold to sell and dis-trioute the '''super-premium'' icecream, and Arnold became Haagen-Dazs' first distributor to supermar-kets. By the late 1970s, Martin IceCream Co.,which was owned solelybyArnold's son, Martin, was distrib-uting Haagen-Dazs ice cream tofour major supermarket chains in

THE FLORIDA BAR JOURNAUMARCH 2005 31

the Northeast. However, neitherArnold nor Martin Ice Cream Co.had any written distribution agree-ment with Haagen-Dazs. Martinpreferred the wholesale distributionof ice cream to small independentgrocery stores and food service ac-counts rather than Arnold's focus ofdistribution to supermarkets.

In the mid-1980s, Pillsbury ac-quired Haagen-Dazs and was seek-ing to sell directly to retail supermar-kets and eliminate its distributornetwork. In 1988, Haagen-Dazssought to acquire and terminate itsdistribution agreement with Arnoldand Martin Ice Cream Co.Martin IceCream Co. created a wholly ownedsubsidiary with the goal of spinningoff the supermarket ice cream salebusiness to the new subsidiary withthe distribution ice cream to smallindependent grocery stores and foodservice accounts to be retained byMartin Ice Cream Co. Arnold wasnamed sole shareholder of the sub-sidiary in exchange for stock thatwas granted to him in Martin IceCream Co. Pillsbury executed anagreement with Arnold and the newsubsidiary to acquire the rights tothe supermarket ice cream sale busi-ness in exchange for $1,430,340.Arnold also signed a bill of sale andan assignment of rights. To protectits rights, Pillsbury requested thatArnold and Martin both signnoncompete agreements.

The Tax Court attributed the pur-chase value primarily to two assets:Arnold's personal relationship withthe supermarkets and Arnold's per-sonal, handshake agreement withthe founder of Haagen-Dazs. Thecourt determined that these assetscould not be attributed to MartinIce Cream Co. or its subsidiary be-cause Arnold never had a covenantnot to compete or any employmentagreement with such entities. TheTax Court has long recognized thatpersonal relationships of share-holder-employees are not corporateassets when the employee has noemployment agreement with thecorporation.

In Norwalk, a two-shareholderprofessional service corporation ren-dering accounting services elected to

32 THE FLORIDA BAR JOURNAL/MARCH 2005

liquidate. Although each share-holder had an employment agree-ment that contained noncompeteprovisions, such agreement had ex-pired as of the date of liquidationon June 30, 1992. The corporationhad eight other employees, includ-ing four accountants, but none oftheemployees had signed any employ-ment agreement with the corpora-tion. On July 1, 1992, the two share-holders became partners in anotheraccounting practice and transferredassets distributed to them by thecorporation to the new practice. Thenew practice also employed many of

. the corporation's other employees.~everal of such employees left thenew practice in October 1992 to cre-ate their own firm and took manyof the corporation's former clients(and the new practice's existing cli-ents) away to their new firm. By1997, only about 10 percent of theaccounts serviced by the corporationremained with the new practice. TheIRS alleged that the corporation dis-tributed "customer-based intan-gibles" to its shareholders and im-posed a double level tax (once at thecorporate level under Code §336 andagain at the shareholder level un-der Code §331) with respect to anunreported gain of $870,000. Thetaxpayer countered that the client-related goodwill and intangibles be-longed to the professional accoun-tants who serviced the clients. TheTax Court concluded that withoutan effective noncompete agreement,the clients have no meaningfulvalue for the corporation. The courtreferred to "personal goodwill" asthe personality, personal ability andreputation ofthe individual accoun-tants and does not belong to the cor-poration.1

There are tax cases that havefound the existence of corporategoodwill. For example, in Schilbachv. Commissioner, T.C. Memo 1991-556, the court held that a corporatemedical practice had goodwill de-spite the lack of a covenant not tocompete with its sole shareholderand only physician-employee. Dr.Schilbach had a patient base of be-tween 8,000 and 10,000 due to mak-ing services available on the

patient's schedule, requiring em-ployees to show an interest in thepatients and their families, provid-ing X-ray, laboratory and other ser-vices at the office rather than re-ferring patients to others, acceptingMedicare payments, billingpatient's insurance company di-rectly, and arranging paymentplans for those patients who wereunable to pay. In 1986, Dr.Schilbach decided to sell his prac-tice due to personal medical prob-lems and the termination of hismedical malpractice insurance. Dr.Schilbach followed advice to liqui-date the corporate medical practiceprior to the end of 1986 due to taxlaw changes (the repeal of the Gen-eral Utilities doctrine) and sold hispractice in 1987. The court definedpersonal goodwill as attributable tothe individual skill, knowledge, andreputation of the professional andpractice or business goodwill to in-clude patient lists and records,trained employees, and leases inplace. The court then found someof the goodwill associated in theoperating entity based on the fac-tors set forth above. Accordingly,the analysis of and allocation be-tween personal goodwill vs. corpo-rate goodwill relies upon the par-ticular facts of each case.

3) Definition for fraudulent con-veyance analysis. Although there isnot much case law examining per-sonal goodwill and the rights of acorporate creditor in connectionwith the sale of a company, in Cor-rugated Paper Corp. v.Eastern Con-tainer Corp., 185 B.R. 667 (Bankr.D. Mass. 1995), personal goodwillconsisting of the salesmen's abilityto transfer customer patronage to anew employer is not a corporate as-set subject to the claims of creditors.The court determined that nofraudulent transfer of goodwill oc-curs when the debtor's salesmenacquire new jobs and the debtor'scustomers follow the salesmen tothe new employer. This case is dif-ferent when the employees (e.g.,guards for a service company) con-stitute a product and do not have apersonal selling relationship withthe customer.2

When a corporation is insolvent,it owes a fiduciary duty to its credi-tors to maximize payments to thecreditors. Recently, the BankruptcyCourt suggested that this duty ex-ists in the sale of a business in Inre W:R. Grace & Co., 281 B.R. 852(Bankr. D. Del. 2002). The Bank-ruptcy Court held that W.R. Graceshould have sold the assets toSealed Air in a $4.9 billion disposi-tion of its Cryovac business ratherthan structuring it as a "Morristrust" transaction in which a ma-jority of the consideration was paiddirectly to the W.R. Grace share-holders (approximately $3.7 bil-

Excela™

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the New Grace creditors. The signifi-cant difference between the directpayment to individuals for personalgoodwill and the ~R. Grace bank-ruptcy is that personal goodwill isnot an entity asset and therefore isnot subject to claims by the entity'screditors. Further, if an entity is in-solvent, the entity's creditors have aclaim that has priority over the claimof the shareholders as to the trans-action proceeds. Funds paid directlyto individuals in exchange for per-sonal goodwillavoid the claims oftheentity's creditors and also avoid anypotential breach of a fiduciary dutyto the creditors because the entitydoes not own the personal goodwillnor is it allowing the proceeds fromthe sale of the personal goodwill tobe diverted away from its creditors.

Creating and TransferringPersonal Goodwill

As recognized in Martin IceCream, personal goodwill may beunique and is present only if sup-ported by particular facts. For ex-ample, the executive should not besubject to a contractual noncompeteprovision in favor of his currentemployer. Further, the executiveshould not be subject to anynonsolicitation provision that pro-hibits the executive's contact andsolicitation of his employer's cus-tomers, suppliers, or service provid-ers. Such noncompete provision istantamount to the employer owningthe goodwill of the executive. Theexecutive should have unique quali-fications such as a license to prac-tice law, medicine, accounting, orother profession, related profes-sionallicenses, industry awards rec-ognizing the executive's uniqueabilities, and/or a history of out-standing sales, management, orleadership ability.

If the executive is subject to anoncompete or nonsolicitation pro-vision or lacks certain licenses toreplicate his business with anotheremployer, the executive should con-sider terminating such noncompeteand nonsolicitation provisions andobtain such licenses. The termina-tion of a noncompete that results inthe transfer of goodwill from corpo-

34 THE FLORIDA BAR JOURNAUMARCH 2005

rate ownership to personal owner-ship could be construed as a fraudu-lent transfer if the entity is insol-vent at the time of the terminationof the noncompete agreement. Thisprocess should be done several yearsprior to a transaction with the buyerto avoid any "step-transaction" doc-trine. This process also reduces thevaluation of the employer if the ex-ecutive is doing estate planning andtransferring interest in the em-ployer to his family or is concernedwith an excessive valuation for eq-uitable distribution.

If the corporation has accumu-lated a proprietary list of custom-ers, a certain value should be at-tributed to such list ifthe executiveintends to use such list at his newemployer. Courts vary in valuingsuch list. In the Corrugated PaperCorp. case, the Bankruptcy Courtdid not attribute significant valueto such list. However, in theSchilbach case, the Tax Court as-sociated value to the corporategoodwill associated with the pa-tient list. To avoid issues of reap-portionment of value by the IRS ora court, the executive and/or corpo-ration could obtain a valuation orfairness opinion with respect to thetransaction.

Personal goodwill should betransferred pursuant to an assetpurchase agreement executed by thepurchaser and the executive. Suchagreement should describe the per-sonal goodwill being transferredand include representations by theexecutive as to ownership of such as-sets and that such assets do not ex-ist separate and distinct for the ex-ecutive (as described in theThompson case). Such agreementshould also include exhibits such asa bill of sale and an assignment ofrights (as suggested by the MartinIce Cream case). The purchaser maywant to include any noncompeteprovision within the asset purchaseagreement to obtain a lengthier pre-sumption of reasonability for therestrictive time period pursuant toF.S. §542.335(d)(3)(a) and (e). Theparties may allocate the purchaseprice between assets comprising thepersonal goodwill and the covenant

not to compete.

Benefits of Creating andSelling Personal Goodwill

There are four significant benefitsin the executive's creation and saleof personal goodwill. The first ben-efit is that the proceeds received bythe executive from the sale of per-sonal goodwill are subject to long-term capital gain treatment ratherthan as ordinary income pursuantto Martin Ice Cream and Norwalk.The maximum federal income taxrate for long-term capital gains is15 percent compared to 35 percentfor ordinary income. In addition,long-term capital gains can be off-set by capital losses (subject to anyalternative minimum tax limita-tions) whereas only $3,000 of capi-tal losses may offset ordinary in-come each year. Note that the buyerin Martin Ice Cream required theexecutive to sign a noncompeteagreement. The existence of thisnoncompete agreement did notcause the executive's sale of per-sonal goodwill to be subject to taxa-tion as ordinary income. Thenoncompete agreement was seen bythe Tax Court as necessary by thebuyer to protect its purchase of theexecutive's personal goodwill.

The second benefit is that the pro-ceeds received by the executive fromthe sale of personal goodwillare notsubject to the claims of theemployer's creditors because theexecutive's employer does not ownthe personal goodwill.In CorrugatedPaper Corp., the Bankruptcy Courtdetermined that no fraudulenttransfer of corporate goodwilloccurswhen the debtor's salespersonschange employment and thedebtor's former customers followthesalespersons to the new employer.

The third benefit is that the pro-ceeds derived from the sale of per-sonal goodwill are not subject to aspouse's claim for equitable distri-bution pursuant to the Thompsoncase. However, such proceeds maybe considered in determining ali-mony.

The fourth benefit is applicable inconnection with the conversion of acorporation to a limited liability com-

pany or partnership taxable as a dis-regarded entity or a partnership forfederal income tax purposes. UnderCode §311, a corporation must rec-ognize income equal to the differencebetween the fair market value of anasset and its adjusted tax basis uponthe distribution of such asset to itsshareholder. The corporation mustrecognize the same income upon liq-uidation under Code §336. If a cor-poration has corporate goodwillwithno corresponding adjusted tax basis,the "deemed" distribution of suchgoodwill causes the distributing cor-poration to recognize income equalto the value of such goodwill. If thedistributing corporation is taxable asa C corporation, the shareholderswill have a second tax under Code§301or 331.However,if the personalgoodwill belonged to the executive,the corporation would not have torecognize any tax attributable tosuch goodwillon the conversion froma corporation to a limited liabilitycompany or partnership. Accordingly,a converting corporation wants to en-sure that any goodwill is personaland not corporate prior to such .con-version.

Tax Treatment to BuyerUnder Code §197, the buyer is

entitled to deduct the amount paidin connection with goodwill(whether it is personal or corporate)ratably over 15years. The tax treat-ment to the buyer would be thesame if the buyer purchased corpo-rate or personal goodwill or if thebuyer made covenant not to competepayments to the executive in con-nection with the acquisition of atrade or business. Each such assetis considered a "§197 intangible."Section 197 intangibles also includegoodwill, going concern value,workforce in place, information-based intangibles (including cus-tomer-related information such ascustomer lists and patient or clientfiles), know-how, customer-basedintangibles, supplier-based intan-gibles, licenses, permits, covenantsnot to compete, franchises, trade-marks, and trade names.

Buyers seeking a faster deductionmay attempt to characterize pay-

ments made in connection with acovenant not to compete as paid inconnection with an employment ar-rangement and deduct the pay-ments under Code §162.A covenantnot to compete is a "§197 intangible"if it is entered into in connectionwith an acquisition (directly or in-directly) of an interest in a trade orbusiness. Treasury Regulation§1.197 -2(b)(9) provides that anagreement requiring the perfor-mance of services for the acquiringtaxpayer does not have substan-tially the same effect as a covenantnot to compete to the extent that theamount paid under the employmentagreement represents a reasonablecompensation for the services actu-ally rendered. If the buyer is pur-chasing personal goodwill from anexecutive, the amount paid for suchgoodwill is amortizable over 15years under Code §197 and cannotbe characterized as compensation bythe buyer. Accordingly, the buyermay sacrifice some flexibility bypurchasing personal goodwill fromthe executive rather than includinga noncompete payment within a rea-sonable compensation package pur-suant to an employment agreement.

SummaryAn executive with unique skills,

a strong relationship with its cus-tomers, an excellent industry repu-tation, and no covenant not-to-com-pete should consider structuring atransaction with an acquirer as asale ofpersonal goodwill.The execu-tive can make such sale in conjunc-tion with a sale of other assets bythe executive's employer.This struc-ture provides an executive with abeneficial parachute because thepayments are treated as long-termcapital gain, not subject to equitabledistribution and not subject to theclaims of the employer's creditors.This structure can also be used toconvert a corporation to a limitedliability company or limited partner-ship taxable, respectively, as a dis-regarded entity or partnership forfederal income tax purposes andminimize any gain such corporationwould otherwise have under Code§311 or 336 with the distribution of

such goodwill to its shareholders.To properly structure this trans-

action, the executive needs to planearly by eliminating any covenantsnot to compete agreements. If theexecutive implements this strategyat a time when his employer is in-solvent, such termination could bea breach of the employer's fiduciaryduty to its creditors and a possiblefraudulent conveyance to the execu-tive. However,if structured properly,the executive receives significantbenefits with no adverse tax conse-quences to the buyer. 0

1 Other tax cases have found the ex-istence of personal goodwill, includingMacDonald v. Commissioner, 3 T.e. 720(1944) (holding that goodwillwas attrib-utable solely to an insurance agent-shareholder's personal ability, businessacquaintances, and other individualis-tic qualities and that no tax was appli-cable in the liquidation of his corpora-tion where there was no noncompeteagreement); Longo v.Commissioner, T.e.Memo 1986-217 (holding that a corpo-rate automobile and casualty insuranceagency had no intangible value with afair market value that could be distrib-uted upon liquidation if it was com-pletely dependent upon its key employ-ees who had no noncompeteagreements); and Wilmo~ Fleming En-gineering Co. v. Commissioner, 65 T.e.847 (1976) (holding that there was noentity goodwillin a family-owned manu-facturing machine shop business inwhich the owners had a dominating in-fluence and overall importance to thesuccess of the business).

2See Robinson v. Watts DetectiveAgency, 685 F. 2d 727 (1982).

Thomas O. Wells is a shareholderin the wealth preservation and tax plan-ning group with the Miami office ofBerger Singerman, P.A. He is board cer-tified in tax by The Florida Bar.Mr.Wellsobtained his J.D. from the University ofSouth Carolina School of Law and hisLL.M. in taxation from the Universityof Florida College of Law.

Daniel Lampert is a shareholderin the transactional department in theMiami office of Berger Singerman, P.A.He concentrates his practice in securi-ties,financing, and transactional law, in-cluding representing buyers, sellers, andlenders in aviation matters. Mr.Lampertobtained his J.D. from New York Uni-versity School of Law.

This column is submitted on behalfof the Business Law Section, Maxine M.Long, chair, and Steven Fender andKevin H. Sutton, editors.

THE FLORIDA BAR JOURNAL/MARCH 2005 35

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