Goodwill and Professional Service CorporationsNovember 18, 2011 – Articles The Legal Intelligencer
In Larry E. Howard v. United States, filed Aug. 29, the 9th U.S. Circuit Court of Appeals upheld the summary judgment decision of the U.S. District Court for the Eastern District of Washington denying a dentist's claim that the portion of the purchase price allocated to goodwill upon the sale of his dental practice represented a long-term capital gain of a personal asset.
Rather, the court, in an unpublished opinion, sustained the position of the Internal Revenue Service that the goodwill in question belonged to the professional corporation and the sale proceeds allocable to that goodwill were taxable as a dividend to the dentist-shareholder. The Howard case highlights the issues concerning the existence and ownership of goodwill in the context of a professional service business and how the disposition of such goodwill should be taxed at either the corporate or shareholder level.
The facts in Howard are relatively straightforward. In 1980, Dr. Larry E. Howard incorporated his dental practice, referred to in the opinion as the Howard Corporation, and became the corporation's sole shareholder, officer and director. In connection with the incorporation of his practice, Howard also entered into an employment agreement and a noncompetition agreement with Howard Corporation that provided Howard, so long as he held any stock in Howard Corporation and for a period of three years thereafter, would not engage in the practice of dentistry within 50 miles of the Howard Corporation's office in Spokane, Wash.
In 2002, Howard and the Howard Corporation entered into an asset purchase agreement to sell the dental practice to an unrelated dentist. Pursuant to the asset purchase agreement, Howard was allocated $549,900 of the total purchase price for his "personal" goodwill and $16,000 for a covenant not-to-compete with the purchaser. An additional $47,100 of purchase price was allocated to the Howard Corporation's tangible assets. The asset purchase agreement contained noncompetition covenants relating to both Howard and Howard Corporation together with a provision requiring Howard's continuing service to the purchaser's practice.
On their personal income tax return filed for 2002, Howard and his wife reported $320,358 as long-term capital gain income resulting from Howard's sale of goodwill to the purchaser of his dental practice. Upon examination, the IRS recharacterized the goodwill as belonging to Howard Corporation and treated the amount received by Howard as a dividend from Howard Corporation, taxable as ordinary income. Therefore, the purchase price was subject to tax at both the corporate and shareholder levels.
In transactions involving professional service corporations (PSCs), a tax issue of concern has always been the appropriate treatment of goodwill. This issue most often arises in the sale or liquidation of a PSC. For this purpose, a PSC is intended to mean any C corporation whose principal activity is the conduct of a professional-service business, such as a law, medical, dental or accounting practice. The Howard Corporation was a C corporation.
In a PSC, goodwill has been described as the intangibles that attract new clients and induce existing clients to continue using the business enterprise. These intangibles may include an established business or firm name, a general or specific location of the practice, client files and work papers, a reputation for general or specialized services and an ongoing working relationship between the enterprise's personnel and clients. As in Howard, in structuring the purchase and sale of a professional service business owned by a PSC organized as a C corporation, a frequently encountered issue is whether all or any portion of the purchase price should be allocable to the PSC's goodwill. Similarly, on the liquidation of a PSC, consideration must be given to whether any value should be assigned to the PSC's goodwill.
If purchase price is allocated to goodwill on a sale by a C corporation, such an allocation will generally give rise to a "double tax" with the corporation taxed on the sale and the shareholders taxed on the liquidating distributions. Similar double taxation could arise upon a liquidation of a PSC that is determined to possess goodwill. Therefore, most sellers of practices owned by a PSC organized as a C corporation attempt to avoid any allocation of purchase price or value to corporate goodwill. Numerous court decisions have provided guidance on these issues and Howard breaks no new legal ground. However, Howard does illustrate these issues and provides a roadmap for pitfalls to avoid.
The issue of whether a PSC is the owner of its goodwill was squarely addressed by the U.S. Tax Court in Norwalk v. Commissioner. In Norwalk, an accounting practice organized as a C corporation liquidated and several of the shareholders thereafter reorganized their continuing practice as a partnership. In the liquidation, gain was reported at the corporate and shareholder levels based only upon the value of the corporation's tangible assets. Upon examination, the IRS asserted that the corporation also owned "customer-based intangibles" constituting goodwill. Therefore, significant additional gain was to be recognized, according to the IRS, at both the corporate and shareholder levels upon the C corporation's liquidation.
In finding in favor of the taxpayers, the court in Norwalk held that the accounting practice owned no intangibles that could be distributed to the shareholders in a liquidation because such intangibles, including goodwill, were entirely dependent upon the PSC's key employees. The court concluded that unless such employees had entered into noncompetition agreements with the corporation or other agreements whereby their personal relationships with clients became the property of the corporation, all goodwill or other intangible rights belonged to the employees and not the corporation. The decision in Norwalk was consistent with a similar decision by the U.S. Tax Court in the 1998 case Martin Ice Cream Co. v. Commissioner that held, "personal relationships of a shareholder/employee are not corporate assets when the employee has no employment contract with the corporation."
Consistent with the earlier U.S. Tax Court decisions in Norwalk and Martin Ice Cream, the 9th Circuit in Howard concluded that the original noncompetition agreement by and between Howard and Howard Corporation effectively transferred the goodwill of Howard's dental practice to Howard Corporation and the noncompetition by and among Howard, Howard Corporation and the purchaser of the dental practice effectively transferred such goodwill directly from Howard Corporation to the purchaser. In reaching this conclusion, the court rejected Howard's argument that the language of the purchase agreement, which stated that the goodwill associated with the dental practice represents a "personal, noncorporate asset" was not dispositive of the issue, since it did not reflect the economic reality of the transaction.
The court also rejected Howard's argument that the purchase agreement effectively terminated the noncompetition agreement between Howard and Howard Corporation. Here again, the court concluded that such argument was inconsistent with the agreement entered into between Howard Corporation and the purchaser pursuant to which Howard Corporation was required to provide Howard's services to the purchaser's acquired practice.
Based upon the principles established in Norwalk, Martin Ice Cream and several other cases, the 9th Circuit reached the correct result in Howard. However, it also appears that Howard could have easily avoided the double taxation resulting from the finding of corporate goodwill. In organizing PSCs, consideration should be given to the following issues to avoid the tax problems associated with corporate-owned goodwill:
- The issue of double taxation only arises in the context of a C corporation. Had Howard's dental practice been organized as an S corporation, limited liability corporation or some other form of pass-through entity, any gain realized upon the sale of the dental practice would only have been taxed at the shareholder-owner level. For this and other tax considerations, there may be little reason for PSCs to be organized and operated as C corporations.
- There was no business reason why Howard as the sole shareholder, officer and director of Howard Corporation needed to enter into a noncompetition agreement with his own corporation. Although such agreements may be required where there are multiple professionals in a practice, there seems to be little value added by having the sole shareholder of a PSC restrict himself from future competition against his own business.
- It appears that the entire transaction relating to the sale of Howard's dental practice was incorporated in a single document to which Howard, Howard Corporation and the purchaser were all parties. Although the substance of the transaction will control, it is recommended that the form of any transaction be structured to minimize risk. Accordingly, separate employment and noncompetition agreements should have been entered into by Howard, individually, with the purchaser. Again, there seems to be little reason why Howard Corporation needed to enter into noncompetition and related service agreements with the purchaser.
Whether goodwill is deemed to be owned by a professional service business or personally by the professionals can have significant tax consequences upon the sale or liquidation of such business. Numerous court decisions, including Howard, have created relatively clear guidance on this issue. The facts in Howard illustrate how it is possible to ignore this guidance and become subject to the trap of double taxation.
Reprinted with permission from the November 18 issue of The Legal Intelligencer. (c) 2011 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.