Saturday, January 12, 2013

Haagen-Dazs and the King of Insurance

Let’s talk about a tax issue that has been evolving since the 1990s: can corporate goodwill not belong to the corporation itself?

With that tease, you can guess how festive tax CPA conferences can be.

The issue makes more sense if we discuss the associated tax problem. Let’s say that you have a company, and you have organized the company as a C corporation. A C corporation pays its own tax, as contrasted with an S corporation whose income is included on the owner’s personal tax return.  The S corporation owner is taxed on both his/her personal income as well as the business income. That business income can push him/her through the tax rates pretty quickly.

The problem occurs when a C corporation sells its business. If it sells assets (by far the preferred method for the non-Fortune 500), the corporation pays taxes on the sale, distributes what cash is left and then the shareholders get to pay taxes again on their exchange of shares. There used be a way to avoid this result (the General Utilities doctrine), but that option was eliminated back in 1986. This is one aspect of the double taxation associated with C corporations, and is also one of the reasons that many tax practitioners have moved their business clients to S corporations and LLCs.

OBSERVATION: By the way, we may see tax advisors moving their business clients back to C corporations, given the existing and expected Obama individual tax rates.

Let’s aggravate the double taxation by pointing out that a successful business probably has “goodwill,” which is something that a prospective buyer would be willing to pay for.

There was a famous case back in the 1990s called Martin Ice Cream. A father (Arnold Strassberg) and his son owned all the stock of Martin Ice Cream. Arnold had worked the industry for years and developed very strong business relationships. The owner of Haagen-Dazs approached Arnold, as they had been unable to penetrate the supermarkets. Voila – Martin Ice Cream began distributing Haagen-Dazs.

Several years go by. Haagen-Dazs wants to acquire Arnold’s relationships with the supermarkets, but they did not want to acquire Martin Ice Cream itself. A little tax planning and Martin Ice Cream created a subsidiary owning all the supermarket relationships. The subsidiary was spun-off to Arnold. The subsidiary sold all its assets to Haagen-Dazs for $1,500,000.

They now have the IRS’ attention. The IRS wants tax on the sale/liquidation of the subsidiary (a C corporation) as well as taxes from Arnold. Arnold says “I don’t think so,” and the issue goes to Tax Court. The Court determined that Martin Ice Cream never owned the relationships that Haagen-Dazs wanted, so it could not sell them. The relationships belonged to Arnold, who could and did sell them personally. That conclusion sidestepped the double taxation issue of a C corporation selling assets and liquidating. Tax advisors were frolicking in the streets.

We now have a 2012 case along these lines: H & M Inc v Commissioner. H & M was an insurance agency in North Dakota and was owned by Harold Schmeets. Harold was the big dog among insurance agents in that area. Here is the Court:

Despite the competitive market, Schmeets stood out among insurance agents in the area. He had experience in all insurance lines and all facets of running an insurance agency, including accounting, management, and employee training. He also had experience in a specialized area of insurance called bonding, and his agency was the only agency in the area, aside from the bank’s, that did this kind of work. There was convincing testimony that in that area around Harvey no one knew insurance better than Schmeets, and even some of his competitors called him the “King of Insurance.”

Wow! How would you like to be known as the “king of insurance”?

Harold’s deal was different from Martin Ice Cream. He sold the insurance agency for $20,000 but entered into an employment contract and non-compete for $600,000. The IRS argued that some of the compensation from the employment agreement and non-compete was actually disguised payment for the goodwill, triggering the double tax. The IRS wanted a check.

There were some technical problems with the transaction as structured, but in the end the Court determined that H & M did not own the goodwill. It could not sell what it did not own, and the IRS lost the case.

A key fact in both Martin Ice Cream and H & M is that the shareholder and key employee did not have a non-compete with their company. From a business perspective, this meant that neither owner was restricted from going down the street and opening another company competing with Martin Ice Cream or H & M. Granted, neither would do so (of course), but he could.  That could means all the difference in the tax world.

How do advisors handle this in practice? We had a dentist as a client. He owned a two-location practice with another dentist, but he was the majority shareholder and by far the key man. Upon investigation, we discovered that the attorney had drafted – and our client had signed – a non-compete with his dental practice. The situation was complicated because there was another shareholder, but we recommended that the non-compete be terminated. A significant portion of the practice’s value was patient loyalty, and the value of this asset (think goodwill) would be materially impaired if our client opened a competing dental practice down the street.

COMMENT: If this is you, please review whether you have a non-compete in place. Many times attorneys draft such documents on a near-routine basis. That doesn’t mean that it makes sense for your situation, however.

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