Making a dealership sale viable: personal goodwill sales price allocations

     The discussion surrounding a dealership business sale typically begins with a focus on net sales proceeds (proceeds after paying all debts and taxes). The tax cost of a sale is driven by several factors: the dealership’s entity structure, its tax attributes, and shareholder and employment agreements. These factors can either be favorable or unfavorable from a tax perspective.

      For example, if a dealership is a C corporation, the tax cost of an asset sale generally includes two levels of taxation—once at the corporate level and again at the individual level upon distribution or liquidation. This double taxation can also apply to an S corporation that had previously been taxed as a C corporation, if such asset sale occurs within 10 years of the S election (although a shorter period may apply).

      Sellers faced with the prospect of a tax applying at two levels typically want to sell stock rather than assets to avoid the double taxation. Buyers, however, nearly always want to purchase dealership assets to benefit from a basis step-up, if one is available. This conflict between buyer and seller often results in a compromise and, depending on the relative negotiating positions, a reduction in the sale price.

      One possible solution to this conflict would be to identify value-for-value exchanges that may relate to the shareholder or employee’s personal consideration, such as covenants not to compete, employment agreements, and other uniquely personal assets. This requires careful consideration of all the elements of value being exchanged, however. Another such asset recognized by courts in certain circumstances is personal goodwill (as opposed to business goodwill or a non-compete agreement).

      Let’s look at an example. XYZ Motors, a C corporation, sells its assets to National Auto Co. for $15 million and then liquidates, distributing the proceeds to the shareholders. Of the $15 million, $5 million was goodwill. XYZ Motors will pay 34 percent tax on the goodwill, or $1.7 million. When the money is distributed to the shareholders, they’ll pay capital gains tax on $3.3 million ($5 million minus $1.7 million), or $660,000. That leaves $2.64 million left for the shareholder of the $5 million in goodwill.

      On the other hand, if XYZ Motors sells its assets for $10 million and the shareholder negotiates for, and sells, personal goodwill for $5 million, then the shareholder pays capital gains tax of $1 million on the sale and none of the goodwill is taxed at the corporate level. The tax savings amount to $1.36 million ($2.36 million minus $1 million).

      Valuing personal goodwill takes into account the percentages or dollar amounts of the goodwill allocated between the dealer and the corporation. There are several factors to consider, including:

      The number of years the dealer has been active in the dealership

• The amount of personal identification of the dealer principal with the dealership (appearance in media advertising, community events or involvement, etc.)
• The franchise agreement terms—does the agreement name the dealer principal, and is the agreement identified as a personal services contract? (See Akers v. Commissioner, 6 TC 693 [1946], and Zorniger v. Commissioner, 62 TC 435 [1974].)
• Personal customer relationships and personal sales

      Personal goodwill started appearing in transactions shortly after the landmark cases of Martin Ice Cream Co. v. Commissioner, 110 TC 189 (1998), and Norwalk v. Commissioner, TCM 1998-279. Personal goodwill allocations in sales agreements, if upheld, avoid the double taxation of either C corporations or the built-in-gains tax imposed on S corporations that have too recently been converted to C corporations.

     This beneficial treatment has become highly sought after but won’t be successful without careful consideration and documentation of all the supporting facts. Case law has now developed several criteria that personal goodwill must meet to sustain court scrutiny. Here are some factors to consider:

     Does any personal goodwill exist? Typically it does exist in an owner-managed business in which the identity or operations of the business is closely associated with that of the owner.

• Has there been a valuation of personal goodwill? Valuations of personal goodwill have become increasingly important in recent court decisions. In some businesses there may be a higher personal goodwill amount versus corporate goodwill. In other businesses there may be very little personal goodwill. Without a valuation you may not have adequate support for your allocation.
• Was there an existing non-compete agreement or employment agreement with the dealer and his or her dealership corporation? This has been held to eliminate the existence of personal goodwill.
• Was there a negotiation between buyer and seller for the personal goodwill allocation? Last-minute additions of personal goodwill allocations (or no allocation) in sales agreements have been held to eliminate the ability to allocate a portion of goodwill to personal goodwill. The payment documentation at closing should align with the personal goodwill allocation and the proportion attributed to corporate intangibles. (See Solomon v. Commissioner, TCM 2008-102, in which taxpayers lost because there was no reference in the sales agreement to personal goodwill.)
• Will there be a new non-compete agreement with the buyer? If there will be a non-compete agreement with the buyer, there should be a bargained-for fair market value allocation of the purchase price to the non-compete agreement as well. This allocation should be supported by the valuation allocations (see H&M Inc. v. Commissioner, TCM 2012-290).

      Valuations prepared in this setting must also consider the relevant corporate goodwill components to ensure the resulting allocation is supportable—for example, the value of the dealership’s assembled workforce or a favorable lease, to the extent that such asset would be included in the transaction. Preparing a personal goodwill valuation proximate to the sale date is also essential, since the seller will have limited access to the necessary information to prepare such an analysis post-closing. (See Muskat v. United States, 554 F.3d 183, 1st Cir. 2009, in which taxpayers lost as a result of adding personal goodwill as an afterthought, on an amended return.)

      To conclude, through careful planning, appropriate sales price and terms negotiation, and documentation, including valuations, the benefits of a personal goodwill allocation in a sale of a dealership can be very advantageous. However, sellers should take care not to shortcut the process and become yet another in a series of unfavorable court decisions.