When the Goodwill Is Personal

“I don’t understand,” said 13-year-old Noah over breakfast last Sunday. He’d just seen a replay of one of his favorite Red Sox players, Manny Ramirez , hitting a two-run homer for the Los Angeles Dodgers to spark their Saturday night victory.

“The Sox just gave him away. They’re even paying his salary for the rest of the season to play for the Dodgers. And we got nothing from them in return?”

My grandson cut his teeth learning shrewd Monopoly trades, but he was totally unprepared for the Boston Red Sox to break up their three-four hitting combo of David Ortiz and Manny Ramirez in a three-way deal involving the Pittsburgh Pirates and several other players. As far as Noah was concerned, Manny was The Man.

Heavily into the process of launching his own athletic career, Noah long ago decided that he didn’t have time for Fantasy Baseball. If he had, there’s no doubt who’d have been his #1 pick. “Who else is a sure Hall of Fame player on the Sox?” he asked me, with impeccable logic.

Certainly with Noah (and many other Sox fans), Ramirez after eight years of home run heroics had built up such a storehouse of goodwill that Noah was willing to overlook Manny’s “me-first” attitude toward teamwork. Noah even admitted that he could probably beat Manny’s standard 90-foot jog to first base on infield grounders, which we regularly timed at more than 5 seconds,

I paused between my spoonfuls of Wheaties (yup, even now) to deliver the lesson of the day – “It just goes to show what happens when one player thinks that he’s bigger than the team. He won’t get away with that with the Dodgers. [Manager] Joe Torre will just bench him. After all, he’s not costing them any money.”

After a lifetime of preaching the value of teamwork to my kids and their kids, imagine my surprise last month when I discovered that there occasionally can be a payoff when one player is bigger than the rest of the team.

Here are the key ingredients:

  • A sale of the assets of the company (as opposed to a stock sale).
  • The Selling Company is a C Corporation, which is subject to double taxation.
  • The Buyer is paying a premium price, above the book value of the assets being purchased. The difference between the two is ordinarily accounted for as corporate “goodwill,” and this gain is taxed at the Selling Company’s regular rate (usually 35% for federal; perhaps another 10% for the state). When the company is then liquidated and the proceeds distributed to the owners, each of them is subject to further personal taxation at capital gains rates (15% federal; 5.3% in MA).
  • If, however, this premium value, or at least part of it, can be attributed primarily to the capabilities, experience, connections, and/or technical expertise of the Selling Company’s owner or senior management team, the concept of “personal goodwill” applies. The result? – The whole level of corporate taxation is bypassed.

My particular example involved a client which was purchased by a Massachusetts company last month in a deal structured as a sale of assets for $3MM. The tangible assets (equipment, accounts receivable, inventory, furniture and fixtures) totaled about $1.2MM. The remaining $1.8MM is normally classified as goodwill on the Acquirer’s balance sheet, and it ordinarily would have been recognized as income by my client’s C Corporation and taxed at nearly 45%. The remainder would have been taxed again, at 15% + 5.3%, when the proceeds were distributed to the two shareholders (husband and wife). So $1.8MM would have dwindled to about $790,000, net, to them.

Instead, based on the expert advice of Attorney Tom Wells , it became clear that what the Buyer was acquiring was primarily the unique personal talents and abilities of the Selling Owner. Without him, there was little premium value that could be attributed to his company. What’s more, because my client never had entered into a non-compete agreement with his company or assigned to the company any of his rights (why would he?), it will be difficult for the IRS to make the case that the company owned all the goodwill. Potentially, by avoiding the corporate-level tax, my client ends up with $1,435,000, an improvement of some $645,000.

So what’s the lesson here? Can star players on closely-held C Corporation teams go their own way to the Hall of Fame? Can they avoid a Non-Disclosure Agreement, retain all of their rights, and find a good agent to represent them even as they admire their work while jogging to first base? Not if they want to stay on the team (you listening, Manny?).

But when the corporate game is all over, and it’s about adding up the score for yourself vs. the taxing authorities, don’t be modest about giving yourself a lot of credit, especially when it’s your company. If it comes down to personal goodwill, you could be a winner. Manny clearly is not.

Alligator Bites

There are two different types of corporate structure, the standard C Corporation and its alternate, the Sub-chapter S [of the IRS Code] Corporation. Business owners electing one or the other should consider the differences carefully: once elected, it can take as long as ten years to unwind a C-Corp choice in order to avoid the “double taxation” assessment.

The key differences:

  1. The profits of C Corporations are taxed at the corporate level and, subsequently, its dividends are taxed as personal investment income. By contrast, the profits of an “S” flow through to its stockholders in proportion to their ownership, and they pay taxes on those profits at their individual tax rates. There is no tax at the corporate level, so there is no double taxation as with a “C.”
  1. An S Corporation is limited to 100 shareholders; C Corporations can have an unlimited number.
  1. C Corporations may have non-US resident shareholders; not so, an S Corp.
  1. S Corporations may be owned by individuals only (with one or two exceptions); the C Corp can be owned by another C or S Corporation, an LLC, partnership, or trust.
  1. C Corporations may have multiple classes of stock; the S, only one.

Draining the Swamp

“Upper-incomers are bearing a record share of the U.S. income tax burden. The top 1% of filers paid 39.9% of all federal income taxes for 2006, up half a point from 2005. That group reported [earning] 22% of adjusted gross income. The top 5% of earners paid 60.1%. The lowest-earning 50% paid just 2.99% of taxes.”

from the Kiplinger Letter, August 1, 2008