Tax Connections Newsletter – Winter 2015
Personal Goodwill Offers Opportunities for M&A Planning
Parties to merger and acquisition (M&A) transactions involving closely-held corporations may enjoy certain tax benefits if they can allocate a portion of the purchase price to individual shareholders’ personal goodwill. Although the IRS does not much like personal goodwill, a recent Tax Court case (see the Sidebar “Personal Goodwill is Alive and Well”) confirms that it remains a viable tax-planning tool under the right circumstances.
Personal versus Business Goodwill
The International Glossary of Business Valuation Terms defines goodwill as “that intangible asset arising as a result of name, reputation, customer loyalty, location, products and similar factors not separately identified.” The value of goodwill is usually expressed as the excess of a business’s fair market value over the value of its net tangible assets and its identifiable intangible assets (such as patents, trademarks and other intellectual property).
Personal goodwill is derived from an individual owner’s reputation, training, skills, experience and relationships. In contrast, business goodwill is associated with characteristics of the business itself. In theory, these characteristics, such as company name, reputation, location, products and workforce in place, remain with the business even if key owners or employees leave the company.
When a C corporation sells its assets, the sale proceeds are subject to double taxation. They are taxed once at the corporate level and again when they are distributed to shareholders. An S corporation generally is not subject to federal corporate-level taxes when assets are sold, but if it started out as a C corporation it may be exposed to double taxation on certain “built-in gains” — that is, unrealized appreciation on assets it owned at the time it converted to S status.
Selling shareholders may reduce the impact of double taxation to the extent the purchase price can be allocated to personal goodwill. Personal goodwill belongs to the individual shareholders and not the company, so that particular portion of the purchase price bypasses the corporation and avoids corporate taxes. In addition, payments that shareholders receive for their personal goodwill generally are taxed at lower capital gains rates, as opposed to payments for employment or noncompete agreements which generally are considered ordinary compensation income.
If the transaction is structured as a stock sale, double taxation is not an issue. But allocating a portion of the purchase price to personal goodwill still offers significant benefits. The selling shareholders enjoy capital gains treatment of those amounts and the buyer acquires an amortizable asset (goodwill is amortizable over 15 years). Buyers usually prefer asset sales, in part because amounts paid for assets generate significant depreciation and amortization deductions. Amounts paid for stock, on the other hand, are capitalized and cannot be deducted or amortized. The ability to allocate a portion of the purchase price to amortizable personal goodwill may make a stock transaction more palatable to a buyer.
Supporting the Allocation
To support a purchase price allocation to personal goodwill, it is important to involve an experienced business valuation professional early in the process. He or she can help determine and document the extent to which the business relies on the individual owners’ talents and connections, and estimate the portion of the business’s earning capacity that is attributable to those talents and connections.
However, keep in mind that to treat personal goodwill separately from corporate assets, it must continue to be the shareholders’ property. If the owners have pre-existing employment, noncompete or non-solicitation agreements, they may be deemed to have transferred their personal goodwill to the company, thereby converting it to business goodwill.
Also, it is critical for selling shareholders to take steps to transfer their personal goodwill to the buyer. This may include signing employment or consulting agreements that set forth the selling shareholders’ responsibilities for helping ensure that the buyer retains the benefits of their business attraction and retention power.
If your corporation is contemplating a sale, it is worth investigating whether a portion of the purchase price can be allocated to the shareholders’ personal goodwill. If significant personal goodwill exists, and you can value and document it, you may enjoy substantial tax savings.
For questions, contact Rob Swenson at [email protected] or call him at 312.670.7444.
529 Plans: Fund College Costs the Tax-Advantaged Way
For many taxpayers, the best way to fund a college education is a Section 529 college savings plan, because of the potential tax advantages it offers. Earnings can grow tax-deferred and may be withdrawn free of federal and, generally, state income taxes for qualified expenses. Their contribution limits are much higher than those for other tax-advantaged educational savings vehicles, and they offer estate tax benefits. But, as this newsletter explains, there are drawbacks that should be considered, as well.
If you are a parent or grandparent of minor children, you are likely thinking about their future college educations and the best way to fund them. For many taxpayers, the answer is a Section 529 college savings plan because of the potential tax advantages it offers.
State-sponsored 529 college savings plans allow you to make cash contributions to a tax-advantaged investment account.
Although contributions to a 529 college savings plan are not tax deductible at the federal level, earnings can grow tax-deferred and may be withdrawn free of federal and, generally, state income taxes, provided they are used for qualified higher education expenses. These include tuition, fees, books, supplies and equipment, and certain room and board expenses. Nonqualified withdrawals are subject to taxes and a 10% penalty on the earnings portion.
Although most college savings plans are open to both residents and nonresidents of the state sponsoring the plan, there may be advantages to opening an account in your home state including possible state income tax deductions or other state tax breaks.
Perhaps the biggest advantage of 529 plans is that their contribution limits are much higher than those for other tax-advantaged educational savings vehicles. The tax code does not specify a dollar limit; it simply requires plans to “prevent contributions … in excess of those necessary to provide for the qualified higher education expenses of the beneficiary.” Limits vary by plan, but in general, they range from $150,000 to more than $350,000 per beneficiary.
While 529 plans are designed to fund college expenses, they also provide estate planning benefits. Contributions are considered completed gifts for purposes of gift and generation-skipping transfer (GST) taxes, but they are also eligible for the annual exclusion, which currently shields up to $14,000 per year ($28,000 for married couples) in gifts, to any number of beneficiaries, from gift and GST taxes without using up any of your lifetime exemptions.
Moreover, a 529 plan allows you to “front-load” contributions. This means that you can use up to five years’ worth of annual exclusions in one year. Suppose that a husband and wife open 529 plans for their two grandchildren and that each plan has a $150,000 contribution limit. The couple can immediately contribute $140,000 (5 × $28,000) to each plan free of gift and GST taxes.
For estate tax purposes, 529 plans are a great tool because contributions and future earnings are excluded from your taxable estate despite the fact that you retain a great deal of control over the funds. Typically, you cannot place assets beyond the reach of estate taxes unless you relinquish control (by placing them in an irrevocable trust, for example). But with a 529 plan, you retain the ability to time distributions, to change beneficiaries or plans (subject to certain limitations) or even to revoke the plan and get your money back (again, subject to taxes and penalties).
As great as 529 plans sound, they do have some drawbacks. One is that you are limited to the investment options the plan offers. Another is that you can change investment options only twice a year (up from once a year in 2014) or if you change beneficiaries. But anytime you make a new contribution, you can choose a different investment option for that contribution.
There are also a couple of estate planning drawbacks. First, if you front-load contributions, you cannot make additional annual exclusion gifts to those beneficiaries for five years. Second, if you die within five years after making these contributions, a portion of them will be included in your taxable estate.
President Obama recently proposed reforms to the 529 program in the context of broader education reform. The proposal was intended to simplify the tax benefits for higher education and remove the 529 plan tax break for the top earners. Subsequently, however, the Obama administration dropped the proposal after public backlash.
Right for Your Situation?
If you are interested in putting away money for your children’s or grandchildren’s college education, 529 plans merit a look. They can be especially beneficial if income or estate taxes are a concern. To choose the most appropriate plan for your situation, contact Rob Swenson at [email protected] or call him at 312.670.7444.
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