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.
