State Taxation and Personal Goodwill
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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