When private equity groups are involved in transactions — most commonly when the target entity is structured as a C corporation — utilizing personal goodwill can optimize tax outcomes and enhance the value proposition. When working with a qualified valuation professional, personal goodwill can act as a “deal sweetener” throughout the course of a deal, saving the seller on their taxes due, thanks to how the deal is structured.
What Is Personal Goodwill?
Personal goodwill refers to the intangible value that arises from an individual’s unique attributes that directly contribute to a business’s success. These include personal relationships, specialized knowledge, professional reputation, and industry influence.
Unlike business goodwill, which is tied to the company’s brand, systems and customer base, personal goodwill is considered an asset owned by the individual rather than the business itself. It exists when the individual’s involvement is so integral to operations and client retention that their departure would significantly diminish the overall value of the enterprise. For valuation purposes, identifying personal goodwill requires a clear delineation between contributions arising from the individual and those attributable to the business as a going concern.
Personal Goodwill Requirements
Recognizing personal goodwill requires isolating these individual-driven contributions and distinguishing them from broader organizational assets. To recognize personal goodwill in a transaction, several conditions must be satisfied:
1. Existence of Personal Goodwill
The seller must demonstrate that personal goodwill is present and tied to their unique attributes, such as professional reputation, industry expertise and client relationships, that materially influence the business’s earnings. These elements should be documented prior to the transaction; mere post-sale employment agreements are insufficient.
2. Quantifiable Value
Personal goodwill must have a measurable economic value. This typically requires an independent valuation that separates personal goodwill from business goodwill and other assets.
3. Ownership and Transferability
The goodwill must be owned by the individual seller and capable of being conveyed to the buyer. If the seller is bound by an existing employment or non-compete agreement with the business, courts generally treat the goodwill as a corporate asset. To preserve personal goodwill, the seller should not have contractual obligations that transfer these rights to the company prior to the sale.
Evidence must show that the seller’s personal goodwill is transferred to the buyer, often through post-sale agreements such as employment or non-compete arrangements. Additionally, the transaction documents, including the letter of intent and purchase allocation schedules, must consistently reflect the intent to buy and sell personal goodwill. Both parties should report the allocation consistently for tax purposes.
Failure to meet these requirements may result in the IRS treating all goodwill as business-related, potentially altering tax consequences for the seller.
Characterizing Personal Goodwill vs. Business Goodwill
To identify potential opportunities in your organization or next transaction, below are a few key examples of personal goodwill and business goodwill attributes that our Valuation Services team commonly encounters.
|
Personal Goodwill |
Business Goodwill Characteristics |
| No non-compete agreement exists between the selling shareholder and the company | Non-compete agreement exists between the selling shareholder and the company |
| Business is highly dependent on individual’s personal relationships, industry expertise and professional reputation | Larger business with formal organizational structure, processes and controls |
| Individual’s service is important to the sales process | Sales are generated from company brand name recognition, company sales team |
| Shareholders are highly involved in operations | Businesses with diversified customer base |
| Businesses with few and high-volume customers | Asset-intensive manufacturing businesses or companies |
| Companies that are highly technical or specialized | Selling shareholder is not intimately involved with the business |
| Companies with contracts that are terminable at will | Companies with deep management teams |
| More common in companies with higher portion of intangible assets | Companies that have long-term contracts with customers |
| Loss of key individual would not materially impact the company’s revenue and/or profitability |
Source: Stout
Personal Goodwill Tax Benefits
Recognizing personal goodwill not only impacts valuation but also plays a critical role in optimizing tax outcomes for both parties in the transaction.
Tax Advantages for the Seller
- Single Level of Taxation: Amounts allocated to personal goodwill are taxed only once at the individual level rather than being subject to both corporate and shareholder taxation.
- Favorable Tax Rates: Proceeds attributed to personal goodwill are generally treated as long-term capital gains, which are taxed at lower rates compared to ordinary income.
- Reduced Corporate Tax Burden: Allocating value to personal goodwill decreases the amount attributed to corporate assets, thereby reducing the taxable gain at the entity level.
Tax Advantages for the Buyer
Personal goodwill purchased from an individual seller can typically be amortized over 15 years for tax purposes, creating a future deduction that lowers taxable income.
Implementing Personal Goodwill Throughout the Course of the Deal
When Conducting Due Diligence
First and foremost, buyers must understand the acquisition target and deal context. Private equity funds should conduct thorough due diligence to identify whether the business's value is significantly tied to the personal attributes of key individuals, which may include personal relationships with clients or referral sources, niche areas of expertise or a strong personal reputation in the industry.
Personal goodwill is often a critical component in the healthcare industry due to the reliance on the reputation and relationships of key medical professionals, such as physicians, surgeons, veterinarians and dentists. Their personal connections and expertise can be a major driver of patient referrals and institutional credibility. Businesses in many other professions and industries may also heavily rely upon key individuals who create significant personal goodwill.
When Enhancing Appeal and Documenting
By strategically leveraging personal goodwill, private equity groups can create value not only by optimizing tax outcomes but also by enhancing the appeal of their acquisition to sellers. This approach requires careful planning, a deep understanding of the target business, and collaboration with tax and legal experts. It is imperative that the existence of personal goodwill be documented as the deal is being evaluated and, ideally, should be addressed in the letter of intent.
When Acquiring Assets
When acquiring assets from a C corporation, recognizing and allocating a portion of the purchase price to personal goodwill can mitigate the double taxation issue. This involves paying for the personal goodwill separately, which is taxed at the capital gains rate directly to the individual, bypassing corporate tax, a difference of nearly 20%.
When Acquiring Stock
When acquiring stock of a C corporation, the use of personal goodwill can also be valuable to the buyer, as they can amortize the personal goodwill over 15 years, rather than allocating the purchase price to the stock of the target, which would result in a tax benefit only in the event of a future exit.
For example, in healthcare transactions, this could entail valuing and purchasing the goodwill associated with a physician's reputation.
When Structuring Deals
The buyer should work with the seller to identify and document the components of personal goodwill, which can be supported by an appraisal that provides quantitative and qualitative support of the individual’s contributions to the business’s success. Proper legal agreements are necessary to delineate the sale of personal goodwill separate from business assets.
By structuring deals to include personal goodwill, private equity groups can facilitate more tax-efficient transactions for sellers, increasing the attractiveness of the deal and maximizing the transaction proceeds to the seller.
When Negotiating the Purchase Price Allocation
During negotiations, private equity groups can propose to allocate a portion of the purchase price to personal goodwill, with the intention of reducing the amount attributed to business goodwill and potentially lowering the overall tax burden. The sooner personal goodwill is addressed in the negotiations and subsequently documented in agreements and supported by a qualified valuation, the more likely the allocation is to withstand scrutiny.
Risk Management, Legal and Compliance Considerations for Personal Goodwill
Private equity groups must ensure that any allocation of personal goodwill is legally sound and compliant with tax regulations by drafting clear agreements and maintaining robust documentation. They should engage tax, valuation and legal advisors to navigate the regulatory complexities to ensure that the allocation will withstand scrutiny from authorities.
Consulting with tax professionals and engaging assistance from valuation professionals to prepare a valuation report is an important step to properly document and support the personal goodwill allocation.
Be aware of the potential for tax authorities to challenge the allocation of personal goodwill, especially if it appears to be primarily in place to avoid taxes. Clear rationale and evidence are essential, so private equity groups should assess the risk of potential disputes with tax authorities and be prepared to defend their allocation decisions.
Let Us Guide You Forward
By effectively leveraging personal goodwill during transactions, private equity funds, especially those specializing in the healthcare industry, can optimize tax efficiencies, create additional value and enhance the overall appeal of their pending deal. This approach requires careful planning, industry-specific insights, and collaboration with tax and valuation professionals to minimize risk.
Cherry Bekaert’s Transaction Tax and Valuation teams, both with deep experience in the healthcare industry, can help your fund evaluate if personal goodwill can be utilized in your transaction and save you — and the seller — money in tax liabilities.
