Who owns goodwill?
The case of Howard v. Commissioner
Goodwill is an intangible asset that arises from a business’s name, reputation, customer loyalty, location, products and other similar factors. It represents the likelihood that customers will return to the business in the future without contractual obligations.
Goodwill can be owned by a business or by an individual practitioner. Personal goodwill is frequently associated with professional firms that rely on the owners’ skills, training and reputation. The classification of goodwill has important tax and legal consequences, as observed in a recent case.
In Howard v. Commissioner, the main issue was the proper classification of goodwill from the sale of a dental practice that had a noncompete agreement in effect on the closing date.
Larry Howard began practicing dentistry in 1972 and incorporated his practice in 1980. A sole practitioner, he entered into an employment contract and noncompete agreement with Howard Corp. upon incorporation. The noncompete agreement prevented Dr. Howard from participating in a similar business within three years of selling his stock within a 50-mile radius of Spokane, Wash.
In 2002, Dr. Howard retired and sold his practice to Dr. Finn. The parties agreed to allocate $47,100 to business assets, $16,000 to the noncompete agreement, and $549,900 to Dr. Howard as personal goodwill.
The IRS audited Dr. Howard’s 2002 federal tax return, which included a long-term capital gain of $320,358 for personal goodwill from the sale of his dental practice. The IRS reclassified this amount from personal goodwill to a noncompete agreement, a corporate asset. Because of the difference between long-term capital gains rates and dividend income rates, Dr. Howard was charged a deficiency of $60,129 and interest of $14,792.
Dr. Howard paid the IRS charges, but filed a claim for a refund. In court, Dr. Howard used state divorce case law to support his personal goodwill classification. (In Washington, personal goodwill is a marital asset, not a business asset.)
To counter this, the IRS cited Norwalk v. C.I.R., which states “there is no [business] goodwill where … the business of a corporation is dependent upon its key employees, unless they enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships with clients become property of the corporation.”
The federal district court of the Eastern District of Washington agreed with the IRS. It held that Dr. Howard was an employee of Howard Corp. with a noncompete agreement valid from 1980 through 2003, plus three years, or to 2006. The noncompete prohibitions would likely discourage patients from following Dr. Howard to a new location. Therefore, any goodwill generated during that time period was Howard Corp. goodwill, not a personal asset of the dentist.
This case teaches many interesting lessons. First, it shows how noncompete agreements may get in the way of taxpayer attempts to claim personal goodwill when they retire. After all, the difference between long-term capital gains rates and dividend income rates can be significant. The case also highlights the need to modify (or terminate) noncompete and employment agreements as practitioners approach retirement.
A tricky situation
Divorce attorneys might want to review the arguments made in this case when dealing with marital estates that include private business interests. Although tax precedent may not be binding in family courts, Howard might persuade a judge to reconsider how goodwill is classified. When a noncompete agreement exists, a professional service firm’s goodwill could be a corporate asset.
Whether for tax, divorce or financial reporting purposes, purchase price allocations can be tricky and often necessitate the use of appraisal professionals. •