Who Sold That Goodwill: The Corporation or the Shareholder?
By Melvyn B. Ruskin, Esq. and Adam J. Gottlieb, Esq.
Today most physicians, dentists, accountants and other professionals practice in entities established under state law as professional limited liability companies (“PLLCs”), limited liability partnerships (“LLPs”) or professional corporations (“PCs”). PLLCs, LLPs and PCs that have elected S Corporation status under the Internal Revenue Code generally enjoy pass-through tax status.This allows all profits and losses of the business entity to pass-through to the individual(s) owning the entity, resulting in a single tax paid.
However, many professionals who may consider selling their practices, originally established the entity as a C Corporation for tax purposes which will generally trigger a double tax that can consume in excess of 50% of the sale proceeds.Unless carefully planned, the sale proceeds will first be taxed at the corporate level of 35% (federal) in addition to a state rate, which can be as high as 9% (without consideration of federal benefit.) If the Corporation liquidates and distributes the remaining sale proceeds to the shareholder(s), the distribution will be taxed at the personal level at the federal dividend rate at 15% in addition to the state rate.
Take the following simplified example (“Hypothetical #1”) in which a zero basis has been assumed for all items:
If the proceeds of the sale are $1 million, the federal and state tax at the corporate level would be about $400,000 (net of federal benefit for the deduction of state taxes.) Upon distribution of the remaining $600,000, there would be another $90,000 in federal tax and about $30,000 in state tax (net of federal benefit) assessed to the owners personally.Thus, there could be a whopping 52% overall tax bite resulting in the owner retaining only about $480,000 from the $1 million sale price.
One way to minimize such a tax impact would be for the shareholder to sell his shares of the Corporation to the buyer. Unfortunately, this is seldom acceptable to the buyer of a professional practice for two reasons:
- First, it subjects the buyer to the malpractice exposure of the seller, a risk buyers are generally unwilling to accept.
- Second, the buyer cannot depreciate or amortize any portion of the purchase price attributable to the underlying assets.
However, as discussed below, there is a history of federal tax litigation that takes into consideration the economic realities of a transaction and indicates that sometimes a different structure can result in more favorable tax treatment for both the buyer and seller. Where the shares of the C Corporation are owned by one or more professionals who do not have contracts of employment or restrictive covenant agreements with the PC and the primary assets being sold are the name, reputation and customer and referral source loyalties, analysis of the economic realities may reveal that the goodwill actually resides in the licensed individual and not in the PC.Thus, a transaction can be structured in which the buyer:
- purchases the PC equipment, furniture, a leasehold, leasehold improvements, phone numbers, and patient or client records and zero or a small amount of goodwill,
- purchases from the licensed professional(s) individually his/their personal goodwill, name, reputation and patient and referral source loyalty, and
- enters into an employment agreement or independent contractor agreement with the licensed professional(s) which contains a restrictive covenant and reasonably compensates the professional(s) for work to be provided after the closing.
When it comes to professionals, it has long been recognized that the guts of a purchase and sale deal is the ability of the buyer to secure the goodwill of the seller and have confidence that the seller’s patients or clients will continue to patronize the buyer.It is clear that if a buyer acquires all of the hard assets of a PC but does not acquire the personal goodwill of the PC’s owner, the buyer will be left holding the bag if the owner opens a competing office across the street.The patients and referral sources of the owner will not patronize the buyer but will go to the owner’s new practice across the street. The professional individual owns the most valuable asset, i.e., the patient and referral source loyalty and reputation that composes his personal goodwill.
Prior to 1986, utilizing what had become known as the General Utilities doctrine, a corporation could distribute its appreciated assets to its shareholder(s) without incurring a corporate tax.The shareholder(s) would pay tax and receive a stepped up basis to fair market value. The shareholder(s) could then sell the assets at fair market value with no additional tax impact.Shareholder(s) benefited by the corporation not being subject to tax on the distribution of appreciated assets.As this was deemed to be a “loophole,” the Tax Reform Act of 1986 repealed the General Utilities doctrine and required corporations to recognize gain on the distribution of appreciated assets in addition to the shareholder(s) being subject to income recognition upon receiving the assets distributed.
However, all was not lost for the shareholder(s) of certain PCs established as C Corporations for tax purposes.In 1998, the Tax Court cases of Martin Ice Cream Co. v. Commissioner and William Norwalk, et al. v. Commissioner established the proposition that a Corporation has no saleable goodwill where its business is dependent upon its key employees, unless those employees entered into a covenant not to compete with the corporation or other agreement whereby the owner’s personal relationships with clients and referral sources became the property of the corporation.
The Martin and Norwalk cases seem to remain good law today and were cited by the Tax Court as recently as August 2010 in Howard v. US. In this case, which held against the individual taxpayer, Dr. Howard was the sole owner of a PC, but signed an employment agreement and a covenant not to compete with the PC in 1980. In 2002 the PC entered into an Asset Purchase Agreement in which about 90% of the purchase price was allocated to Dr. Howard’s personal goodwill.The Tax Court rejected this position distinguishing the Martin and Norwalk cases and held that the goodwill belonged to the PC because of the existence of the employment agreement and the restrictive covenant agreement with Dr. Howard.The facts and economic realities in Howard did not support the taxpayer, but the case affirms the vitality of the tax doctrine established in Martin and Norwalk.
Consider the alternative tax implications as illustrated by following simplified example (“Hypothetical #2”) and in light of the economic realities and the doctrine established by the Martin and Norwalk cases:
The buyer executes an Asset Purchase Agreement with a PC to purchase the PC’s assets for $60,000 comprised of $35,000 in furniture and equipment, $12,500 in phone and fax numbers, $12,500 in records and charts and zero goodwill because the PC does not have an employment agreement and restrictive covenant agreement with the PC’s owner.The buyer contracts with the individual professional for his professional services over a number of years (at a reasonable salary) which includes payment of $100,000 for a restrictive covenant. At the same time, the buyer purchases the most important asset, the individual’s goodwill, directly from the individual, for $840,000, pursuant to a clear and well-drafted sale of goodwill agreement.
The tax consequences of these transactions assume the tax basis of all items is zero.The PC will be subject to corporate federal and state level taxation on the full $60,000 sale proceeds.The individual professional will be subject to ordinary income taxation on the payments received related to the restrictive covenant, in addition to federal capital gains taxation and ordinary state income tax on the proceeds of the sale of his personal goodwill.
Based on the foregoing, the total tax bite will be approximately $240,000 (24%), determined roughly as follows:
- $24,000 paid by the PC for federal and state taxes (net of federal benefit) on the $60,000 sale of assets.
- After the PC assets are sold, the remaining net cash of $36,000 will be distributed to the professional and taxed at dividend rates resulting in an additional $7,200 for federal and state income taxes (net.)
- $40,000 paid by the professional for federal and state taxes related to $100,000 paid for his restrictive covenant.
- $126,000 for federal taxes and $42,000 for state taxes (net) related to the purchase of personal goodwill.
If the owner is not subject to the Alternative Minimum Tax, the owner could end up retaining $760,000 of the $1 million consideration.
Under Hypothetical #1, the business owner would net $480,000 of the sale proceeds compared to $760,000, assuming Hypothetical #2. Accordingly, it is incumbent upon the attorney and accountant, prior to the commencement of negotiations, to identify asset ownership and goodwill valuation when considering a sale of a professional corporation.
The above article merely summarizes simple transactions related to the sale of a professional corporation. We suggest that any sale be carefully considered and attorneys and accountants consulted related to specific tax and personal considerations.
About the authors:
Melvyn B. Ruskin, Esq. practices corporate and health law and is the founding partner of Ruskin Moscou Faltischek, P.C. in Uniondale, Long Island. He can be reached at 516-663-6650 or firstname.lastname@example.org. Adam J. Gottlieb, Esq. is Of Counsel and a CPA at Ruskin Moscou Faltischek, P.C. and concentrates his work in the areas of Trusts, Estate and Taxation. He can be reached at 516-663-6507 or email@example.com.