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By Richard Reichler, Esq. Meltzer, Lippe, Goldstein & Breitstone, LLP, Mineola, NY
Personal goodwill has been recognized as an asset separate from business goodwill. For federal income tax purposes, personal goodwill minimizes the value of corporate assets but allows the sale proceeds to be allocated to an asset which is amortizable by the buyer and results in capital gain to the seller. The state tax implications of the sale of personal goodwill, however, have not received appropriate consideration.
Although many non-public businesses are organized as an LLC which is entitled to pass through federal income tax treatment, this is not always the case. Many such enterprises have been around long enough to have been formed prior to the availability of LLC statutes. Moreover, many successful enterprises have been organized as pass-through Subchapter S corporations, particularly if such a structure significantly limits social security taxes. Even though the sale of the assets of S corporations can be structured to avoid the burden of double taxation imposed on C corporations, the restrictions imposed by the Subchapter S stock distribution rules can negatively impact the desired allocation of sale proceeds. For example, the distribution of sale proceeds other than in proportion to equity ownership can raise Subchapter S qualification issues unless the difference is handled as compensation rather than capital gains. Also, the distribution of income can create corpus to a trust shareholder whose income beneficiaries may be anxious to avoid such distributions in order to minimize their estates.
A non-tax consideration in allocating sale proceeds to personal goodwill is the possible insulation of those proceeds from the claims of the business creditors. Although there is a paucity of case law regarding this issue, one case, Corrugated Paper Corp. v. Eastern Container Corp., 185 B.R. 667 (Bankr. D. Mass. 1995), held that personal goodwill consisting of the salesmen's ability to transfer customer patronage to a new employer was not a corporate asset subject to the claims of creditors. The court determined that no fraudulent transfer of goodwill occurs when the debtor's salesmen acquire new jobs and the debtor's customers follow the salesmen to the new employer. The result is different if the employees (guards for a service company) do not have a personal selling relationship with the customer. See Robinson v. Watts Detective Agency, 685 F.2d 727 (1982).
The U.S. Tax Court has recognized the existence of personal goodwill as a separate asset. See Martin Ice Cream v. Comr., 110 T.C. 189 (1998); Norwalk v. Comr., 76 T.C.M. 208 (1998). The more generic of these cases is Martin Ice Cream, which centered around a nonprofessional with a substantial personal relationship with customers and potential customers of the business. That case involved the sale of an ice cream distribution business to Haagen-Dazs. One of the shareholders, Arnold Strassberg, entered the business of distributing ice cream products after World War II. Strassberg's skill in packaging and sales campaigns helped solidify his relationships with the owners and managers of various supermarket chains. Strassberg's ideas paved the way for ice cream to be sold under individual brands, in varying levels of quality, and in distinctive containers. Strassberg's reputation garnered the attention of Haagen-Dazs's founder, who asked Strassberg to introduce Haagen-Dazs ice cream to supermarkets. Based on his relationships, Strassberg was able to obtain shelf space for Haagen-Dazs ice cream and, for the first time, introduce super premium ice cream to supermarket consumers. A written distribution agreement or contract was never entered into between Haagen-Dazs or its founder and Strassberg or Martin Ice Cream. In 1983, the Pillsbury Company acquired Haagen-Dazs and sought to acquire the distribution business conducted for Haagen-Dazs, as well as direct access to Strassberg's contacts in the supermarket industry. Strassberg sold the distribution rights with Pillsbury paying $1.2 million directly to Strassberg for seller's rights.
The IRS disputed Strassberg's ownership of the saleable goodwill. However, the Tax Court held that the goodwill attributable to Strassberg's relationship with the supermarket owners, his reputation, and his relationship with the founder of Haagen-Dazs were never corporate assets and always belonged to Strassberg himself. Because Strassberg never entered into a covenant not to compete or even an employment agreement, his relationships never became assets of the corporation.
Thus, the Tax Court recognized that for federal income tax purposes personal goodwill was involved in a corporate enterprise owned by affiliated shareholders.
For state income tax purposes, if the executive is physically present in the multiple jurisdictions, it would appear that a state could assert that the intangible created by his activities (including personal goodwill) is constitutionally subject to tax under the “source” principle if the state tax law so provides. If the executive is not physically present but the business in which the intangible is used operates in multiple jurisdictions, an issue arises as to whether the executive is subject to multistate taxation. In effect, is there sufficient nexus between the state and the owner of the intangible to constitutionally justify the imposition of tax on the income of the owner of the intangible.
In Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the Supreme Court affirmed an earlier decision of the Court that physical presence was constitutionally required in order to impose a duty to collect sales tax. This left open the issue as to whether physical presence was required for nexus for state income tax purposes in order for the state to obtain personal jurisdiction over physically remote persons to require them to comply with a direct tax payment obligation. A year after the decision in Quill, the South Carolina Supreme Court upheld an income-based tax under the Commerce Clause, ruling that substantial nexus was created by the use of the taxpayer's trademarks within the taxing state. See Geoffrey, Inc. v. S.C. Tax Comm’n, 437 S.E.2d 13, 18 (S.C. 1993), cert. denied, 510 U.S. 992 (1993). The South Carolina Supreme Court held that “by licensing intangibles for use in this state and deriving income from their use here, Geoffrey has a 'substantial nexus' with South Carolina.” Geoffrey, 437 S.E.2d 23-24. Since Quill, the clear majority of the state courts that have addressed the issue have similarly declined to apply a physical presence requirement to an income-based tax. See, e.g.,Geoffrey, Inc. v. Okla. Tax Comm’n, 132 P.3d 632, 638 (Okla. Civ. App. Ct. 2006) (trademark licensing); Lanco, Inc. v. Dir. Div. of Taxation, 908 A.2d 176, 177 (N.J. 2006), cert. denied, 127 S. Ct. 2974 (2007); A&F Trademark, Inc. v. Tolson, 605 S.E.2d 187, 195 (N.C. Ct. App. 2004), cert. denied, 546 U.S. 821 (2005); Kmart Props., Inc. v. Taxation and Revenue Dep’t, 131 P.3d 27 (N.M. Ct. App. 2001), cert. granted, 40 P.3d 1008 (N.M. 2002), cert. quashed, 131 P.3d 22 (N.M. 2005); Bridges v. Geoffrey, Inc., 984 So.2d 115 (La. Ct. App. 2008); Secretary, Dep’t of Revenue v. Gap (Apparel), Inc., 886 So.2d 459, 462 (La. Ct. App. 2004); Comptroller of the Treasury v. SYL, Inc., 825 A.2d 399 (Md. 2003).
As recognized in Martin Ice Cream, personal goodwill is an asset that must be defined by the facts. Thus, in the usual case, the existence of such an asset can be expected to be accompanied by factors, such as a strong personal relationship with business customers. The development of personal goodwill may involve personal services by the individual in jurisdictions other than the state of residence, even though the proceeds for that asset may be received in a tax period in which there is no such presence. However, the state corporate income tax cases discussed herein suggest that, if the state tax law so provides, the use of personal goodwill by a related company can provide Commerce Clause nexus for tax by states in which the intangible is utilized, even if there is no physical presence by the owner of the intangible and the state tax law. Of course, for many businesses, the state of residence of the owner of the intangible and the business in which it is employed will be the same. This will be true in almost any case in which the personal goodwill is utilized in a business or profession requiring a state license to practice that occupation. However, in other cases, practitioners should examine whether the state income tax law to determine the risk of taxation of income derived from personal goodwill because of its use in the jurisdiction by an affiliated person. That examination will have to be undertaken against a background of continuing failure by the Supreme Court, including in recent decisions, to grant certiorari with respect to the issue of whether the physical presence requirement in Quill applies in other than sales tax collection situations. See, e.g., Geoffrey, Inc. v. Comm’r of Revenue of Massachusetts, 453 Mass. 17 (Mass. 2009).
For more information, in the Tax Management Portfolios, see Rothman, 561 T.M., Capital Assets.
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