Since goodwill is measured as the excess of a business value over the value of its net assets, valuation analysts may also test for the existence, and the value, of goodwill by determining whether the subject business is able to generate earnings over and above a reasonable rate of return on: (1) the value of assets, plus (2) a reasonable compensation for the services performed by the business owner. If a business generates a return sufficient only to compensate the owner for the capital invested in its assets and provides a reasonable return for his or her labor, it has no goodwill.
The valuation of goodwill is not only important from an accounting and tax perspective. Its existence and value may also be an issue when determining whether a business has suffered economic damage in cases such as breach of contract and intellectual property infringement. In such cases, economic damages may be measured as the loss in the value of goodwill due to the wrongdoer’s actions.
In addition, goodwill, or a portion thereof, has long been recognized as “property” in matters related to the distribution of business assets in matrimonial litigation. In a number of situations, particularly tax and matrimonial cases, it is often important to distinguish whether the goodwill in a company belongs to the business itself, or if it is personal goodwill of the business owner.
Business vs. Personal
Business goodwill is created by the location, reputation, longevity, assembled assets and operating procedures of the institutional practice. For example, if a company is known for manufacturing reliable products at a fair price, the value of that reputation is due to the performance of the company as a whole, not to that of any single person. However, many companies have goodwill that is not only attributable to the business but also to the owner.
Some service-based businesses such as professional practices may have goodwill that is entirely attributable to the owner. Personal goodwill is created by the reputation and skills of the individual practitioner or business owner. The existence of personal goodwill is based on the fact that customers, clients or patients come to the individual practitioner or business owner because of his or her skills, knowledge and reputation. Without this person’s particular set of skills and knowledge, the customers, clients or patients would go elsewhere.
Valuing goodwill and distinguishing between personal and business is entirely dependent on the facts and circumstances of each case. Ultimately, the allocation of goodwill between personal and business is driven by the degree to which the success or failure of the business depends upon the individual’s personal services.3 Most of the goodwill is likely to be personal if:
(2) the operations of the company is not functionally or economically separate from the individual, and
(3) the success of the company is directly interrelated to the activities of the individual. 4
In the early stages of a company’s operations, most internally created goodwill is personal. As the company increases in size and complexity, goodwill typically shifts from the personal to the business category.
The extent of personal goodwill in a company’s value may also be affected by the circumstances surrounding its proposed sale, including the extent to which the current owner will compete with the business after the sale.
For example, if an accountant is valuing his practice for a sale and is not planning on joining the new firm, the value of the practice’s goodwill, if any, will not include personal goodwill. Presumably, any clients that used the practice only because of their relationship and trust of the professional will likely not stay with the existing practice under a new owner. Also, goodwill that appears to be personal may in fact be business goodwill if the personal goodwill is attached to the subject business through agreements such as employment or non-competes.
Tax issues are often behind the attempt to allocate the value of goodwill between the business owner and the business entity.
Tax Treatment
In many cases, a tax benefit may be realized by allocating goodwill to the owner rather than the business and thereby minimizing the business entity’s value.
For example, when a C corporation sells its assets and distributes the proceeds to its shareholders, the overall tax liability can be reduced substantially if some portion of the sales proceeds is allocated to the shareholders as personal goodwill, rather than to the business entity.
Upon a sale of corporate assets, the amount of gain taxed at the corporate level is the difference between the sales price and the corporation’s basis in its assets. Often, the corporation will liquidate after the sale of its assets, and distribute the remaining sales proceeds (already taxed once at the corporate level) to its shareholders. This distribution is taxed again at the shareholder level as a capital gain or loss depending on the difference between the amount distributed to each shareholder and the shareholder’s basis in the stock.
If a portion of the sales price is deemed to be personal goodwill allocable to the shareholder (rather than to the corporation), it will reduce the amount realized at the corporate level, thereby reducing any gain subject to corporate-level tax. The amount deemed personal goodwill will be taxed only once (as capital gains) at the shareholder level.5
An allocation of the value of a company to personal goodwill may also provide tax benefits to the buyer of its stock. When a buyer purchases stock, its cost is not an asset eligible for amortization. However, the amount paid to the selling shareholder for his or her personal goodwill may be amortized over a 15-year period and provide valuable tax benefits to the buyer.
Personal goodwill may also play a role in the calculation of business value for transfer tax purposes (i.e., estate tax and gift tax). In transfer tax cases, the value of a business is measured using the fair market value standard (which involves a hypothetical willing buyer and willing seller). Since the taxpayer typically desires a low business valuation for estate and gift tax purposes, it would be desirable to allocate the value of goodwill, if possible, to the owner rather than the entity.
The reverse may be true for charitable gifts of corporate stock held more than one year. In such cases, a higher value provides more tax benefits. In such cases, the donor would prefer that any goodwill inherent in the value of the stock be allocated to the business rather than the owner.
Personal Goodwill in Family Law
In many states, goodwill (or a portion thereof) has long been recognized as “property” subject to distribution among the spouses in family law cases. However, many state courts have failed to make a clear distinction between personal and business goodwill, and others have just recently begun to consider the matter.
The distinction between personal and business goodwill may be important to the segregation and quantification of separate and marital property, particularly if the business or personal goodwill of the spouse was acquired or accumulated prior to the marriage. The question of when property is acquired by the spouse is particularly important in a marital dissolution because property obtained prior to the marriage (separate property) is usually returned to its owner, while marital property is divided between the spouses.6
It is common for a spouse’s income to increase over time as he or she acquires skills that complement existing abilities. However, only if the increase in income occurs because of the effects of the marriage should it be attributed to the marriage, thereby becoming marital property.7 Likewise, if the increase in a business’ value is attributable to the personal goodwill of one of the spouses, and this asset was developed prior to the marriage, many states find the value of the business attributable to the personal goodwill of the spouse is not a marital asset subject to equitable distribution.
The treatment of personal goodwill for martial dissolution purposes is ultimately a decision decided by the courts in each state. While there is no unanimity, the majority acknowledge the presence of goodwill in a closely held business. The state court decisions to date fall into the following four general categories:8
2. business goodwill is considered marital property while personal goodwill is separate property, approximately one-half of the courts;
3. neither personal nor business goodwill is considered marital property; less than 10 percent of the courts;
4. no decision or no clear decision; less than 10 percent of the courts.
