When It Comes to Goodwill, Planning is Key

Part of our job as dental practice attorneys at Nardone Limited is to help dental practice owners plan for the long term. We understand that it is important for dental practice owners to be aware of how structuring a business and the agreements they enter into may affect their tax liabilities, both in the short term and the long term.

What is Goodwill?

The Internal Revenue Code defines goodwill as “the value of a trade or business attributable to the expectancy of continued customer patronage.” According to the Internal Revenue Service (the “Service”), when valuing businesses, goodwill may be based primarily on earnings, and factors such as (i) the prestige of the business; and (ii) the ownership of a trade or brand name. A record of successful operation over a long period of time in a particular location may also furnish support for the inclusion of goodwill.

The taxation of goodwill is a very important issue when it comes to the sale of dental practices. Courts tend to ask two main questions for purposes of the taxation of goodwill: (i) who created the goodwill; and (ii) did that person transfer the goodwill. It is important to determine who created the goodwill, by analyzing: (i) whose relationships drive the dental practice’s success; (ii) whose special knowledge is used in the dental practice; (iii) whose ability or skill generates the revenue; and (iv) whose reputation is used to draw or retain customers.  Courts may look at contractual relationships between the owner and the dental practice to determine if the person transferred goodwill through an employment contract or a contract not to compete. A good example of what courts may look at in regards to the contracts is the Howard case, which is described below.

The Howard Case

There was a case a few years ago, which involved Dr. Howard, a dentist, who sold his professional service corporation (the “Corporation”) to another dentist by an asset sale. Howard v. United States, 2010 U.S. Dist. LEXIS 77251, 3, 2010-2 U.S. Tax Cas. (CCH) P50, 542, 106 A.F.T.R.2d (RIA) 5533 (E.D. Wash. 2010). In the Howard case, the asset purchase agreement allocated approximately $550,000 for the personal goodwill of Dr. Howard. Dr. Howard asserted that any goodwill was a personal asset subject to taxation as a long-term capital gain. The Service argued that any goodwill belonged to the Corporation and must be characterized as a dividend payment taxed as ordinary income. Dr. Howard sued for a tax refund in federal district court. The district court agreed with the Service and held that goodwill was a corporate asset of the Corporation. Dr. Howard appealed to the Ninth Circuit.

On appeal, the Ninth Circuit looked at: (i) the employment contract between Dr. Howard and the Corporation; (ii) Dr. Howard’s covenant not to compete; and (iii) the asset purchase agreement.

The Employment Contract

Under the employment contract, the Corporation controlled which clients it accepted or rejected. The Corporation also controlled client records and files. In the employment contract, Dr. Howard agreed to “practice dentistry solely as an employee of the Corporation and to devote his entire professional time to the affairs of the Corporation.”

Covenant Non-Compete

Under the non-compete agreement, Dr. Howard agreed not to engage in any business that competed with the Corporation while Dr. Howard held any stock in the Corporation, or for the three year period following his ownership of any stock. Neither the employment contract nor the non-compete agreement expressly stated who owned any generated goodwill.

Asset Purchase Agreement

The asset purchase agreement stated that “the personal goodwill of the practice [was] established by Dr. Howard… [and] is based on the relationship between Dr. Howard and the patients.” Dr. Howard had also entered into another non-compete agreement with the purchaser of the Corporation, in which Dr. Howard agreed that he would not practice dentistry within ten miles of the practice for three years.

Dr. Howard argued that according to the asset purchase agreement, the goodwill was personal to him and therefore, it controlled the tax treatment of the goodwill. The Ninth Circuit disagreed and held that the substance of a transaction controlled, not the form of a transaction.

Dr. Howard then argued that the asset purchase agreement operated to transfer the accumulated goodwill back to him personally. He also argued that the asset purchase agreement controlled over his preexisting employment contract and non-compete agreement with the Corporation. Ultimately, the Court held that even if it agreed with Dr. Howard’s arguments, the release of goodwill back to Dr. Howard would still constitute a dividend under Section 316(a) of the Internal Revenue Code.

Planning Strategy

As shown in the Howard case, courts will look at both corporate and employment documents to determine who created the goodwill and was that goodwill ever transferred. It is important to remember that when goodwill is a corporate asset and is purchased in an asset sale, the goodwill can be treated as a dividend from the corporation to the professional. If goodwill is transferred, it is ideal to have it taxed as a capital gain instead of as ordinary income. But, if the goodwill is treated as a dividend, it is subject to double taxation, at both the corporate level and the shareholder level. Thus, to reap the most benefits from a tax perspective, the goodwill needs to belong to the individual, not the entity. To recognize and benefit from a capital gains treatment on the consideration allocable to goodwill, the ideal way to structure the transaction is for (i) the shareholders to sell their stock, or the corporation its assets; and (ii) the shareholders should separately sell their personal goodwill.

Ultimately, you want goodwill to belong to the individual, not the entity. This is done through an employment agreement that gives the company the ability to control the future services of an individual. It is ideal if corporate resolutions and minutes, in addition to the employment agreement, all expressly state that any goodwill stays with the individual employee or owner.