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— Industry Insight —
While dealflow has been down significantly this year, the consistent message I hear from my clients is the push to get the most value out of their deals. In a recent deal, the client was purchasing a C corporation from eight individuals who had started the business 10 years earlier and needed additional funding to expand the business. Since the target was a C corporation owned by individuals, the transaction could not be structured to achieve a tax basis step-up. However, we increased the deal value by allocating a portion of the purchase price to the personal goodwill of the founding shareholders. In addition, the allocation to personal goodwill was structured so the tax preparers could sign the return in good faith and the auditors were comfortable with the FIN 48 posture. Care was taken in the reasoning and documentation to avoid any adverse financial statement impact. Buyers like to structure transactions as asset acquisitions because it cleanses many historical liabilities and provides a tax basis step-up. A tax basis step-up results in higher tax deductions for tangible and intangible assets, which translates to reduced cash taxes. Unfortunately, many deals, like my client's recent deal, could not be structured as an asset acquisition. Transactions can generally be structured as asset acquisitions where there is one level of tax -- for example, when acquiring assets from a partnership or LLC. A transaction can also be structured as an asset acquisition from a C corporation if the C corporation has sufficient net operating losses, or NOLs, to absorb any corporate level gain. Finally, transactions can be structured as asset acquisitions when the target is an S corporation, though many S corporation transactions are structured with a Section 338(h)(10) election, which provides a tax basis step-up, though it is legally structured as a stock acquisition.
However, when the target is a C corporation with no NOLs and is owned by individual shareholders, no tax basis step-up is generally available. A tax benefit may be available in these circumstances if the acquisition is bifurcated into the purchase of the stock and the purchase of the selling shareholders' personal goodwill. If the purchase price is bifurcated, the purchaser would be able to obtain tax amortization for the amount allocated to personal goodwill, and this amount can be amortized over 15 years on a straight line basis. As previously mentioned, allocation of personal goodwill would only occur in an acquisition from individual shareholders, not from the acquisition from a corporate owner. The sellers would generally not be disadvantaged because gain from the sale of personal goodwill is taxed at capital gains rate, the same as the gain from the sale of stock, though there is a risk that the Internal Revenue Service would reallocate amounts paid for personal goodwill to a noncompete agreement, which would be taxable at ordinary income rates. The current notion of personal goodwill is based on the seminal case, Martin Ice Cream v. Commissioner. The Martin Ice Cream case stands for the proposition that an individual can own goodwill, hence personal goodwill, which is separate and distinct from the assets owned by his or her corporation. Personal goodwill is generally an intangible asset held by an individual relating to a business. Typically, personal goodwill is associated with the individual shareholder's business relationships or specific expertise. In the Martin Ice Cream case, Arnold Strassberg was hired to introduce a product into supermarkets because of his close personal relationships with supermarket owners and managers. His efforts successfully launched Haagen-Dazs, which Pillsbury Co. eventually acquired in 1983. After the acquisition, Pillsbury wanted to control the supply chain and consequently wanted to buy Strassberg's company, Martin Ice Cream Co. The negotiations between Strassberg and Pillsbury lasted several years and were started and terminated a number of times, with the terms changing over time. Although the IRS disagreed with the tax treatment of the sale as reported on the company's income tax returns, the Tax Court held that the tax return treatment was proper because Strassberg, individually, owned the goodwill associated with the business. The Martin Ice Cream case was the first step in the use of personal goodwill to add value to acquisitions. The second step was the change in the tax law. Prior to 1993, goodwill was never deductible or amortizable for tax purposes. In August 1993, the law was changed to allow for amortization of all intangibles, including goodwill, on a straight line basis over 15 years. Thus, the Martin Ice Cream case, together with the change in law, opened the door for allocating purchase price to personal goodwill, thereby providing a tax benefit to purchasers of corporate stock where no tax basis step-up is available. While no case has yet considered the tax amortization of the acquisition of personal goodwill, recent cases have looked at the issue and disallowed it -- for example, where the taxpayer has requested a refund based on the use of personal goodwill even though the concept was never discussed during the structuring of the deal or where the sellers had no valuable relationships or know-how. Nonetheless, the case law has shown that the courts recognize personal goodwill as an asset owned by the shareholder/employee that is separate and distinct from the corporation's assets. Though the current state of the law supports amortization of acquired personal goodwill, it also emphasizes the need for proper upfront tax planning and proper documentation to successfully support an allocation to personal goodwill. An allocation to personal goodwill should be included in the deal negotiations from the beginning, rather than a last-minute change to the deal structure. The negotiations and deal terms should include a post-acquisition employment/consulting agreement, as well as a noncompete agreement. It should be confirmed that the selling shareholders have the strong relationships, expertise, reputation and know-how associated with personal goodwill. It should also be confirmed that the selling shareholders do not have any pre-existing employment or noncompete agreements with the target company. At the end of the day, valuation is generally a question of fact and thus the courts may require strong factual support in allocating purchase price among the equity, the noncompete and the personal goodwill. Although never free from dispute, a contemporaneous third-party valuation would be more difficult for the IRS to rebut. While some parties have relied on the allocation negotiated between the buyer and seller, believing that the allocation inherently reflects fair market value, such allocations may hold less weight in the eyes of the IRS, where the parties' interests are not necessarily divergent. From a compliance perspective, the buyer's compliance team must have sufficient factual and legal grounds to support signing a return in which personal goodwill is amortized, as well as assessing the FIN 48 reporting position for the financial statements. Having an independent third-party valuation to support the allocation will assist in meeting these compliance burdens. We note that the typical private equity investment has historically had a three- to five-year horizon. While there would be an incremental tax benefit during the investment period, it should be considered whether there is a sufficient benefit to assume the risk of IRS attention with respect to the portfolio entity, which could extend to other portfolio companies held by that private equity firm. In summary, the value of a deal may be enhanced by allocating a portion of the purchase price to the personal goodwill of the selling shareholders. Although such an allocation requires careful consideration of many factors, it should be considered in negotiation and structuring a transaction. Most importantly, proper tax planning is critical to support such an allocation. Jerome M. Schwartzman is a managing director with Duff & Phelps Corp. and leads the tax due diligence practice. Kevin Katz and TC Fleming contributed to this article. |
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