This week’s tax-saving tips for independent pharmacy owners come from Sean at Integrity Pharmacy Consultants. I highly recommend Sean and his team if you are buying, selling, or transferring a pharmacy. See the original post HERE.
Many people, including experienced attorneys and CPAs, are surprised to learn that an individual owner, shareholder, or member can own a corporation’s or LLC’s rights bundle, known as goodwill. This can greatly reduce the tax burden when selling your pharmacy.
Both enterprise goodwill and personal goodwill can coexist within the same company.
This concept, often highlighted in divorce cases where an ex-spouse seeks compensation or ownership, can also be strategically used to save substantial tax during the sale of a corporation or company.
In a recent case, we helped our client save over $1.2 million in taxes on the sale of their business. This is done by utilizing individual ownership of goodwill and securing a predictable income stream of $150,000 per year for the client and their spouse. This article illustrates how planning with personal goodwill can minimize taxes arising from the sale of a corporation or company.
The Importance of State Law:
Our analysis begins with state law. The Internal Revenue Code (IRC) assesses taxes based on the ownership of property rights to both assets and income. However, these property rights are determined by applicable state law. While the IRC taxes transactions, state law defines and regulates these property rights.
Although the IRC does not define goodwill, IRC Section 197 provides for the amortization of intangibles, including goodwill. State laws recognize that the goodwill of a corporate or company business may accrue to an individual rather than just the business. State law further recognizes that goodwill is a property right or asset that is transferable, much like equipment or other assets. Many cases, particularly in divorce contexts, have defined and described goodwill as a property right.
Since state law recognizes goodwill as a transferable property right, the IRC uses this to define the tax attributes of goodwill. “Company or enterprise goodwill” typically refers to the goodwill of the business or enterprise. “Personal goodwill” refers to the goodwill accruing to the business owner or another individual. Personal goodwill generally reflects the personal skills, reputation, and customer, vendor, and referral relationships attributable to the business owner or other individual.
The Unique Tax Advantages:
The most recognized use of personal goodwill is to minimize tax on the sale of a C corporation, which is taxed under subchapter C of the IRC. This minimization means the corporation pays income tax at the corporate level. When income is distributed to shareholders or owners as dividends, it is subject to a second level of tax. Many corporate sales are structured as asset purchases for two main reasons:
1. Buyers often want protection from seller liabilities that would arise in a stock sale.
2. Buyers can obtain a basis step-up through the allocation of the purchase price to depreciable or amortizable assets. This provides substantial tax benefits.
For example, in the asset sale of a $6 million C corporation, the corporate-level tax might be $2.058 million for federal and state purposes. When income is distributed to shareholders, the tax might be $1.971 million. This results in a combined tax rate exceeding 70% for federal and state taxes.
If $2 million is instead allocated to personal goodwill, this amount is taxed to the business owner as a capital gain. This results in savings of over $1 million because personal goodwill is not subject to the corporate tax rate of over 30% and is taxed only at the individual level as a capital gain.
A Lesser-Known Application:
A lesser-known application is for the sale of a subchapter S corporation, which is taxed under subchapter S of the IRC. An S corporation does not pay federal tax at the corporate level; income is taxed similarly to a partnership. The taxation of goodwill is not subject to a second level of tax and is characterized as a capital asset taxed at the favorable capital gains tax rate.
Some of the best tax minimization strategies involve transferring part of the asset to be sold to a charitable entity before the sale. For example, a recent sale of a business for $6 million resulted in tax savings of over $1.4 million by contributing personal goodwill to a lifetime income charitable pooled trust before the sale. This contribution allowed the seller to invest and receive lifetime income from the amount contributed to a split-interest charitable income fund, providing significant economic benefits for the family.
The Tax Cases:
One of the leading cases on the tax advantages and treatment of personal goodwill is Martin Ice Cream Co. v. Commissioner. Arnold Strassberg sold the assets of Strassberg Ice Cream Distributors, Inc. to Häagen-Dazs. This includes intangible assets like his personal relationships with supermarket owners and managers. The Tax Court recognized these intangible assets as personal goodwill owned individually by Strassberg and not by the corporation. Key factors included Strassberg never entering into a covenant not to compete or an employment agreement with his own company.
Similarly, in H&M Inc. TC Memo 1997-260, the business owner did not have an agreement with his corporation. This precluded him from taking his personal skills and relationships to a competitor or other company.
What You Need to Know:
To utilize personal goodwill effectively, take the following steps:
1. Develop and document the business owner’s personal expertise, skills, and customer, vendor, and referral relationships.
2. Confirm that the business owner has never signed a noncompete agreement or restrictive covenant with the corporation or company before the sale.
3. Negotiate and establish the amount or purchase price allocable to the goodwill being transferred.
4. Use a separate purchase agreement between the buyer and the business owner for selling personal goodwill.
5. Contribute personal goodwill to a separate LLC before the sale. If contributing to a charitable organization, ensure this is done before any binding agreement between the buyer and seller is made.
Proper planning can provide substantial tax savings and increase the wealth retained upon the sale of a family business. Understanding and leveraging personal goodwill can also achieve significant financial advantages.
We highly recommend Sean. If you have any questions, you can contact them via their website HERE.
