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Oct 2014
22
October 22, 2014

Individual Personal Goodwill Can Save Family Businesses Money


Two recent Tax Court cases have extended the concept of personal goodwill to estate and gift taxes in the context of a transfer of a family business. The rulings were significant because they resulted in markedly lower tax assessments on the primary business owners involved in the disputes.

“Personal goodwill” is a concept recognized by the courts whereby an individual, as opposed to their business, is the creator and owner of certain valuable, intangible assets – primarily customer relationships.

Prior to the recent cases, personal goodwill was used when a business was sold and some of the proceeds were allocated to the individual holding personal goodwill that was separate from assets held by the business.

Now it is clear that the personal goodwill of a single family member may save gift and estate taxes relating to a family business. The basic concept is that the recognition of personal goodwill reduces the value of the family business upon a transfer of shares of stock or other ownership interests of the business by, or upon the death of, an owner of the business. 

In one of the recent cases (Bross Trucking, Inc., T.C. Memo 2014-107), the taxpayer was able to convince the court that the personal goodwill held by Dad was not transferred with a trucking business.  Therefore, no gift tax would be due as the gift did not exist. The ruling eliminated IRS assessments on the business and Dad by more than $2 million. The primary customers of the trucking business were businesses controlled by the sons.

In the other case (Estate of Franklin Z. Adell, T.C. Memo 2014-155), the court held that the surviving non-owner son held personal goodwill that reduced the value of a cable uplink service business for religious television programs that was taxed in Dad’s estate. In this case, Dad owned all of the business upon his death, but the son who was the company president secured and maintained personal relationships with third parties that drove the revenue of Dad’s business. The IRS initially asserted a value of the business exceeding $92 million, then reduced that figure to $27 million. The court accepted the taxpayer’s valuation of about $9 million.

The concept of personal goodwill does not apply to all situations and to all types of businesses.  A facts-and-circumstance analysis is needed to determine whether there is personal goodwill and whether the value of that personal goodwill affects the value of the business entity. Valuation reports at the time of death or transfer of shares of stock or other ownership interests are recommended in order to demonstrate the value of the personal goodwill.

A key factor the Bross Trucking and Adell cases analyzed was whether the personal goodwill was, in effect, transferred to the company at some point in time.  That could happen by way of a specific assignment of the personal goodwill, but usually would result from the existence of an employment agreement or a covenant not to compete between the particular individual and the business.

In the Adell case, the father’s business did not have any written employment or other agreement with the son.

Personal goodwill is more common with service businesses as opposed to manufacturing enterprises due to the personal relationships that may drive the revenues of the business. With service businesses, personal relationships with customers and personal goodwill are one in the same. The goodwill generated by manufacturing companies can be attached to the products themselves or brand names. 

These cases have extended the personal goodwill to the estate and gift tax regimes and should be considered by family owned businesses in the context of tax and succession planning. It would be prudent to examine how these cases could impact an existing succession plan, or begin planning for these issues.

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