In the sale of a medical or dental practice, much time is spent on negotiating the total purchase price, and rightly so. But it is often the case that not nearly enough time is spent on the related and quite important issue of tax allocation. When allocating the sale amount to the various categories, questions invariably arise regarding allocation to goodwill. Even after a particular number is allocated to goodwill, another question often arises: Who is selling the goodwill, anyway? This may seem like a silly question. The seller is selling the goodwill, of course. However, in the context of a solo professional practicing in a business entity, the issue can get a bit blurry. Yes, the business entity is technically the practice and the primary contracting party. But the professional’s skill, expertise, reputation and loyal patients are what gave rise to the goodwill.
Take the following example: assume there is a single-shareholder professional corporation (taxed as a C-corporation as opposed to as a pass-through entity S-corporation) that has operated as a medical practice for forty years. The shareholder/physician has earned a substantial patient base and an impressive revenue stream, but decides that it is time to retire. The decades of caring for the community has built up considerable goodwill. The corporation and a buyer enter into an asset purchase agreement. The parties decide that x dollars will be allocated to goodwill. Does that goodwill go to the corporation or to the physician? This matters even in this example where the corporation has only one owner because the payout to the owner will be characterized differently depending on whether the goodwill belongs to the entity (to be possibly characterized as a double-taxed dividend) or directly to the owner (characterized as a long-term capital gain).
Now that we have set the scene, let us briefly discuss the star. Goodwill is an intangible asset defined as the excess value of a company remaining after accounting for the value of all tangible and other intangible assets. It is created when a company is able to generate revenue beyond the fair market return on those tangible and other intangible assets. The tax regulations at 29 C.F.R. Section 1.197-2(b)(1) define goodwill as, “the value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor.” While the definition and description are helpful to ensure that we all understand what we are discussing, they do not help determine whether the company or its owner can claim that reputation or those relationships.
That is why we must turn to case law for the answer. Many cases have addressed issues surrounding and directly related to whether the business entity or the owner thereof can claim the goodwill in question. For critical background, one should review Martin Ice Cream v. Commissioner, 110 T.C. 189 (1998); Norwalk v. Commissioner, T.C. Memo. 1998-279; Estate of Taracido v. Commissioner, 72 T.C. 1014 (1979); Cullen v. Commissioner, 14 T.C. 368 (1950); MacDonald v. Commissioner, 3 T.C. 720 (1944); and Providence Mill Supply v. Commissioner, 2 B.T.A. 791 (1925).
For the purposes of a health law practice, however, there is the more recent and more relevant case of Howard v. United States, from the U.S. District Court for Eastern District of Washington, which came down on July 30, 2010. Unfortunately, the case is not published in the Federal Supplement but it easy to find on your favorite case law database. Howard involves the sale of a dental practice. Dr. Larry Howard began practicing dentistry in 1972. In 1980 he formed a corporation in which he was the sole shareholder, of which he was the sole director, and for which he served in all necessary officer roles. In the same year as incorporation, Howard entered into an employment agreement with his corporation which contained a three-year, 50-mile noncompetition clause centered on the practice’s location in Spokane, Washington. Obviously, the existence of this covenant was Howard’s doing and he had the freedom, at any time, to alter or eliminate it.
In 2002, Howard sold his practice via an asset purchase deal. The total purchase price was $613,000, $549,900 of which was allocated to Howard’s personal goodwill, $16,000 of which was consideration for the noncompetition covenant, and the remaining $47,100 represented the value of the practice’s assets. For that tax year, Howard reported $320,358 of long-term capital gain income from the sale and the IRS recharacterized it as a corporate asset to be taxed as a dividend. The recharacterization earned Howard a $60,129 tax deficiency charge along with interest of $14,792.17. Howard paid same and then filed a claim for a refund.
Relying on Norwalk, Martin Ice Cream, MacDonald, and a U.S. Court of Appeals for the Ninth Circuit case, Furrer v. Commissioner, 566 F.2d 1115 (9th Cir. 1977), among others, the court found that a corporation owns the goodwill where, “an employee works for a corporation under contract and with a covenant not to compete …” Absent such an employment contract, the court continued, then the goodwill may be personal. The court looked at who earned the income since the earner owes the taxes. To make this determination, the court applied a two-part test: whether the individual is an employee; and whether there is a contract showing that the individual recognizes the corporation’s control. Applying this test, the court had no difficulty finding that Howard’s corporation owned the goodwill and earned the income. While Howard had the control to alter or eliminate the noncompetition covenant, it remained in force until Howard dissolved the corporation in 2003.
This decision makes sense when one considers the practical implications of the noncompetition covenant. Since it remained in force as of the dissolution of the corporation, Howard was subject to that covenant through the third anniversary of the dissolution in 2006. The relationships that a dentist fosters to gain goodwill are with the patients. It is highly unlikely that even the most loyal patients will wait three years or travel more than 50 miles to stay with Howard. Thus, the goodwill could not truly belong to Howard so long as that covenant existed. Of course, this brings into question why a solo doctor has a noncompete with his professional corporation in the first place.
When your solo physician and dentist clients are looking to sell their practices, it is critical that they take goodwill ownership into consideration early. Specifically, the client should determine whether goodwill exists, it is transferrable to the buyer, and it is, in fact, personal goodwill. I hope that this article provides some guidance as to the third issue. Finally, since the seller signing the asset purchase agreement will be the entity (as it owns the assets to be sold), the sale must include a separate agreement between the buyer and the shareholder, individually, addressing the transfer of any personal goodwill.
—Andrew Stein, an associate at Lamb McErlane who focuses on health and business law, assisted with preparing this article.
Vasilios J. Kalogredis is chairman of Lamb McErlane’s health law department. He represents many medical and dental groups and thousands of individual physicians and dentists.