When a professional corporation sells its assets or liquidates, one important federal income tax issue is whether the corporation or its shareholder-employees owns any self-created (as opposed to purchased) goodwill.
For tax purposes, goodwill is an intangible asset. It represents the extra value of a business based on expected continued customer patronage due to its name, reputation and similar factors.
Such goodwill often doesn't appear on the corporate balance sheet, because it was developed by the corporation or by its shareholder-employees without any historical cost assigned to it for financial accounting or tax accounting purposes.
If valuable professional goodwill doesn't show up on the corporate balance sheet, it can often be overlooked when evaluating the federal income tax impact of selling the corporation's assets or liquidating the corporation. That could be an expensive mistake.
When a professional C corporation is determined to own valuable self-created goodwill, selling the corporation's assets — including the professional goodwill — or liquidating the corporation can trigger double taxation: once at the corporate level and again at the shareholder level if the shareholders receive more than the tax basis of their shares. On the other hand, if the shareholder-employees are determined to own the professional goodwill, the value of that goodwill won't be exposed to double taxation.
The following two examples illustrate why this matters.
You and your business partner are equal shareholders of TPP Corp., a professional C corporation. After some serious disagreements about the future of the business, the two of you decide to liquidate the corporation and go your separate ways. You each have a basis of $100,000 in your TPP shares, which you've held for years.
Immediately before the liquidation, TPP owns two assets:
Upon liquidation, TPP is deemed to sell its assets for FMV. Therefore, the corporation must recognize a $1 million corporate-level taxable gain on the deemed sale of the professional goodwill. Assume the corporate-level federal income tax is $210,000 (21% of the $1 million gain. In this analysis, we'll ignore potential state income tax implications).
TPP pays the $210,000 tax bill and distributes the remaining cash of $290,000 ($500,000 - $210,000 lost to taxes) and the goodwill worth $1 million to you and your partner in a complete liquidation.
Assume the same basic facts as in Example 1, except this time you and your business partner, rather than TPP, own the professional goodwill.
Now, there's no corporate-level federal income tax liability from liquidating TPP, because it doesn't own any appreciated assets.
You and your partner each receive cash liquidation proceeds of $250,000 in exchange for turning in your stock. These exchanges are treated as regular stock sales. Therefore, you and your partner must each recognize a $150,000 long-term capital gain (stock sale proceeds of $250,000 - $100,000 tax basis in your shares). If the liquidation occurs in 2023, you and your partner could each owe the IRS up to $35,700 (20% maximum federal income tax rate on the $150,000 long-term capital gain + the 3.8% NIIT on the gain), for a combined total of $71,400 (2 x $35,700). That would be the overall maximum current federal income tax cost of liquidating TPP. Compare the $71,400 current total tax hit in this example with the $469,420 current total tax hit in Example 1.
However, you're not done yet. You and your partner still own $500,000 of self-created professional goodwill (50% x $1,000,000) with a tax basis of zero. There's no federal income tax hit on the value of the goodwill until you sell it, if you ever do. If you do eventually sell, the taxable gain from the professional goodwill you created will be classified as a Section 1231 gain that'll generally be favorably taxed as a long-term capital gain as long as you owned the goodwill for more than one year. As mentioned earlier, the current effective maximum federal income tax rate on a long-term capital gain is 23.8% (20% maximum rate + 3.8% for the NIIT. But if you never sell the goodwill, there will never be a tax bill.
Bottom Line: From a federal income tax perspective, shareholder ownership of professional goodwill is generally more beneficial than corporate ownership, because there's no double taxation.
Note: A provision in the Tax Cuts and Jobs Act eliminated some intangible assets (including patents, inventions, models, designs, secret formulas and processes, and copyrights) from the lower-taxed capital asset classification. However, this provision doesn't affect goodwill, which is still classified as a lower taxed capital asset.
Let's take a look at how this issue has fared in the courts. One court decision concluded that a professional dentistry corporation, rather than its sole shareholder, was the owner of professional goodwill worth $550,000 when the practice was sold. Back in 1980, the shareholder entered into an employment contract and noncompete agreement with his corporation. Under the noncompete agreement, he was precluded from having any affiliation with any competitive dental practice within 50 miles of the practice. This restriction lasted for as long as he owned any of the corporation's stock and for another three years after the date when he no longer owned any shares.
Under these facts, the shareholder couldn't leave and take the corporation's patients with him. Therefore, the U.S. District Court ruled that the professional goodwill was owned by the corporation rather than the shareholder. The court wasn't swayed by the fact that the shareholder could have single-handedly terminated the noncompete agreement any time before selling the practice, because he never took that step. Similarly, the court wasn't persuaded by the fact that the sale agreement stipulated that the shareholder owned the goodwill and the buyer paid him directly for it. The court recharacterized the buyer's payment for the goodwill as being made to the corporation, with the amount then distributed from the corporation to the shareholder. That resulted in double taxation on the goodwill value.
Finally, the court and the Ninth Circuit Court of Appeals agreed with the IRS that the existence of the employment contract between the shareholder and the corporation indicated that the business was the income-earning entity. This factor apparently gave additional weight to the conclusion that the corporation owned any professional goodwill generated by the shareholder's efforts. (Howard, DC WA, 7/30/2010; affirmed 9th Circuit 8/29/2011)
What about situations where restrictive employment or noncompete agreements don't exist when a professional corporation's assets are sold or the business is liquidated? Two longstanding U.S. Tax Court decisions can be to be cited to make the case that shareholder-employees, rather than the corporation, own the goodwill associated with the business. (Martin Ice Cream Company, 110 TC 189, 1998 and William Norwalk, TC Memo 1998-279.) While these two decisions are old, they've been repeatedly cited favorably in later decisions.
To make the most convincing argument that professional goodwill is owned by s shareholder-employee rather than the corporation, consider explicitly terminating any employment agreements and noncompete agreements as far in advance of the corporation's sale of assets or liquidation as possible. Then, the two court decisions above can be cited to take a firm position that the shareholder-employees own the professional goodwill — with the kind of tax-saving results illustrated by the preceding examples. Consult your tax advisor about your situation before finalizing any moves.
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