For owners of C corporations, an asset sale can create a significant tax consequence: double taxation. The corporation generally recognizes gain on the sale of appreciated assets, with the amount of gain generally determined under IRC Section 1001, and pays tax on that gain, while shareholders may incur a second tax when the sale proceeds are distributed. As a result, the combined effective federal tax rate can exceed 40% (not including state and local taxes).
In certain circumstances, however, a portion of the purchase price might be able to be allocated to personal goodwill, creating an opportunity to avoid corporate-level tax on that amount.
Personal goodwill differs from enterprise, or corporate, goodwill. Enterprise goodwill belongs to the corporation and is tied to the business itself, including its brand, workforce, systems, customer lists, and going-concern value. Personal goodwill belongs to an individual shareholder and stems from personal relationships, reputation, expertise, and other attributes that have not been transferred to the company. It generally reflects the value of the shareholder’s individual relationships, skills, and reputation that may continue to influence customers even after the business changes hands.
When properly structured and supported, a shareholder may sell personal goodwill directly to the buyer rather than through the corporation. If the applicable holding-period and other requirements are satisfied, the proceeds may be taxed to the shareholder at applicable long-term capital gains rates, including the preferential rates described in IRC Section 1(h), rather than being taxed first at the corporate level. This structure generally results in a single layer of tax on the goodwill portion of the transaction and can generate significant tax savings.
The strongest personal goodwill cases typically involve relationship-driven businesses where customers are loyal to a particular owner rather than to the company. Key considerations include whether the shareholder has previously assigned goodwill to the corporation through an employment agreement or non-compete; whether a qualified valuation supports the allocation of goodwill to the shareholder; and whether the buyer is contracting directly with the shareholder through a separate goodwill purchase, consulting, or non-compete agreement. Professional services, consulting, insurance, and advisory businesses are common candidates, although opportunities may also exist in other industries. Substance-over-form principles are important: the allocation should reflect the transaction’s economic reality, not merely the labels used in the purchase documents.
Because personal goodwill transactions frequently attract IRS scrutiny, contemporaneous documentation and arm’s-length valuation support are critical. The allocation between enterprise and personal goodwill must be defensible, and the buyer and seller should report the transaction consistently. Courts have closely examined personal goodwill allocations in cases such as Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (T.C. 1998), and the case law demonstrates that the IRS may challenge an allocation when the transaction documents, prior agreements, valuation, and the parties’ conduct do not support it.
For business owners considering a sale, evaluating potential personal goodwill early in the process may provide a meaningful opportunity to reduce overall tax exposure and maximize after-tax proceeds. Owners should consult qualified tax counsel and valuation professionals early, so the transaction structure, documentation, and reporting positions can be evaluated in the initial stages of the transaction life cycle..
This article is for general informational purposes only and does not constitute legal or tax advice. The tax treatment of personal goodwill depends on the specific facts and circumstances of each transaction. Readers should consult qualified legal and tax advisors before taking any action based on the information presented herein.
