Putting the "good" in goodwill
NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.
Buyers and Sellers of dealerships are often faced with a large income tax bill at the end of the transaction. The income tax imposed on the seller is usually a double tax caused by the sale of C Corporate assets or an S Corporation with “built-in gains”. This tax problem gives incentive to the seller to insist on a stock sale instead of an asset sale. A stock sale generally results in only a single level tax, at more beneficial capital gain rates.
Therein lies a conflict. Buyers generally don’t want the transaction structured as a stock sale, since they would not be able to deduct the full purchase price of the assets through depreciation or amortization as they would in an asset purchase. Consequently buyers and sellers play tug-o-war with this issue, either compromising on the sale price, or abandoning the deal.
Due to two 1998 Tax Court decisions, it is now possible to allocate some or all of the goodwill in the transaction to the dealer principal on a personal basis, thus escaping taxation at the corporate level. The theory behind this is that in many cases the manufacturers sales agreements are personal contracts with the dealer, and the corporation is only able to sell vehicles through such agreements. Personal versus corporate goodwill can be defined as “goodwill which is intrinsically tied to the attributes, reputation and/or skills of certain individuals.”
While the two 1998 Tax Court decisions do not deal with automobile dealerships, both emphasize the fact that shareholders may possess valuable assets that can be sold on an individual rather than a corporate basis. In Martin Ice Cream Co., 110 TC No. 18 (1998) the tax court held that intangible assets were owned by the owner of the company as an individual and therefore not attributable to the corporation. InNorwalk,TCM 1998-279, the court held that, without an effective non-competition agreement, a client list of a CPA firm had no meaningful value to the firm and that the goodwill attributable to an existing base of clients belongs instead to the accountants (individually) who serviced them.
When coupled with several other court decisions, some specifically relating to automobile dealerships (refer toFloyd D. Akers, 6 TC 693 andFrank E. Zorniger v Commissioner,62 TC435) , the ability to significantly reduce the tax on a sale or purchase of a dealership becomes a reality . Additionally the savings can benefit both the buyer and the seller, and can be realized in either an asset sale or a stock sale. The concept involves the valuation of personal goodwill that is owned by the dealer instead of being an asset of the dealership.
Typically the sale of a business assumes that the corporation owns the goodwill, or blue sky as it is commonly called. It is entirely possible, however, that the major portion of the goodwill actually is a result of the owner’s efforts, name, and reputation, and is therefore not really an asset of the corporation. The court decisions listed above have established the concept of “personal” goodwill, which means that the goodwill can be allocated both to the individual shareholder/dealer and the corporation, or maybe even all to the dealer.
The portion which is properly allocated to the dealer would not be subject to the double tax which exists in a C Corporation, and the purchaser of personal goodwill would be entitled to a 15-year amortization of the goodwill purchase. This results in a tax savings to both the buyer and the seller.
This concept is one that needs to be evaluated carefully by your professional advisors,. and iIt is probably desirable to actually have two buy/sell contracts, one for the corporate assets and one for the personal assets., hHowever the potential tax savings can be very attractive as the following example illustrates.
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 blue sky. XYZ Motors will pay 34% tax on the blue sky, or $1.7 million. When the money is distributed to the shareholders, they will 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 blue sky.
On the other hand, if XYZ Motors sells its assets for $10 million, and the shareholders sell personal blue sky for $5 million, then the shareholders pay capital gains tax of $1 million on the sale, and none of the blue sky is taxed at the corporate level. The tax savings amounts to $1.36 million ($2.36 million minus $1 million).
There are several factors which must be considered when valuing personal goodwill, and the percentage of the goodwill that is allocated to the dealer and the corporation, including:
- The existence of an employment contract or non-compete agreement at the time of purchase.
- 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, etc.)
- The franchise agreement terms
If the dealer already has an employment agreement or non-compete agreement with the dealership prior to the sale, this would weaken the case for assigning any goodwill personally. If the dealer signs a non-compete agreement with the buyer and some of the purchase price is allocated to it, this strengthens the argument for assigning personal goodwill.
If the franchise agreement is actually under the name of a corporate entity rather than the individual dealer, then this is also a factor that would weaken the case for personal goodwill.
Suffice to say that this concept is well worth the effort in tax savings to explore with your attorney, accountant and valuation consultant as you structure the buy/sell transaction.
This article was written in 1999.