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Personal Goodwill

Personal Goodwill

by | May 27, 2016 | All Blog Entries, Corporate

Allocation of goodwill to personal goodwill can alter individual tax liability on the sale of a company.  Personal goodwill should be valued by a third-party valuation firm.  It should be clearly identified in the purchase price agreements and agreed to by the acquirer.

Recent Tax Court decisions in Bross Trucking, Inc., T.C. Memo. 2014-107, and Estate of Adell, T.C. Memo. 2014-155 continue to show the Tax Court does differentiate between personal and corporate goodwill.  The personal goodwill concept is typically associated with the landmark case Martin Ice Cream Co., 110 T.C. 189 (1998).

In Martin Ice Cream, the United States Tax Court decided that the majority shareholder’s relationships with his clients were not owned by the corporation as the shareholder did not have either an employment agreement with the Company nor a covenant not to compete.  Therefore, the goodwill associated with this was not the asset of the Company but an asset of the shareholder himself.

Personal goodwill is dependent on the personal characteristics of the business owner.  Personal relationships, ability, personality, and reputation of a shareholder-employee key to the business’ success must be defined and supported.

Quantifying the proportion of personal versus business goodwill is often based on factors associated with the shareholder-employee such as these:

  • Age and health
  • Demonstrated earning power
  • Community reputation for judgment, skill and knowledge
  • Comparative industry success
  • Nature and duration of person’s role in creating company profits
  • Personal relationship with customers
  • Importance to developing new business
  • Personal involvement in solving client problems
  • Critical role in financial/operational decisions
  • Direct impact on profitability
  • Personal knowledge, experience, known-how and abilities

A vital test is whether the individual holds the right to sell the goodwill.  It must be the shareholder’s asset that was not previously transferred to the corporation. Evidence of such transfers include employment agreements and non-compete agreements.

Multiattribute Utility Model

The Multiattribute Utility Model (“MUM”) is a commonly-used tool to allocate goodwill between personal goodwill and enterprise goodwill.  It calls for the analyst to identify key attributes of goodwill and segregate them between personal and enterprise goodwill.  Attributes span industries.

To each attribute, a weight of importance (with 1 as the lowest and 5 the highest) is assigned.  Attributes include those above and are fine-tuned for each situation.  An attribute is weighted based on the importance of the attribute to the person and enterprise. The weights determine the allocation between personal and corporate goodwill.

As with any valuation, each allocation of weight must be supportable.  Our philosophy at JBV is if you can’t support it, don’t state it.

At JBV, we are here to assist you.

Buy/Sell Agreements & Valuations

Buy/Sell Agreements & Valuations

by | May 6, 2016 | All Blog Entries, Corporate

Owners of small businesses enter into buy/sell agreements with their partners to protect their interests in their largest investment, their business.  The presence of such an agreement is essential to ensure a clean succession and to protect heirs.  We applaud the efforts, but not always the process or results.

Much time is spent agonizing over details. Elaborate definitions of earnings are created; multipliers are agreed upon; the requirement for discounting is debated.  All these factors, and others, are agonized over.  Countless hours spent and professional fees incurred to arrive at a plan deemed acceptable to all, a daunting task.

Creating a hard-and-fast formula for a buyout can be a mistake.  Businesses evolve.  Products change, services are added or deleted.  The nature of the business itself can change.

The lifetime of a small business can span many years or even several decades.  The nature of our economy, and our society, has changed significantly over these periods.  Not long ago, a garment manufacturer designed, manufactured and distributed their products from their own facility in the U.S.  Today, they are, in essence, distributors.  While they design and distribute, manufacturing takes place overseas.  With smaller companies, these contract manufacturers are not captive to them, adding a layer of complexity and cost.

Industries have changed in other ways.  SEC regulation of hedge funds, the emergence and disappearance of Blockbuster in a matter of a few decades are milestone changes in industries that just recently started. The onslaught of iTunes, Spotify and Pandora in the music industry has led to the virtual end of sales of albums.  Uber threatens to end the taxi and limo industry as we know it.  Just two examples of major upheavals in traditional industries we never considered would change.  Formulas set even just a few years ago may no longer be relevant.

A better and more cost-effective solution for a buy/sell is to appoint a valuation firm to handle the project.  A baseline valuation is performed which is then updated every one, two or three years.  In some cases, no update to the baseline valuation occurs until a triggering event happens.  In either case, appointing a firm that all partners agree to can avoid dissension at a critical and often emotional time.

Designing a buy/sell should be an integral part of an operating agreement.  An attorney and a tax specialist ought to be consulted.

At JBV, we are here to assist you.

83(b) Elections and the Smaller Business

by | Apr 27, 2016 | All Blog Entries, Corporate, Employee Compensation

We continue our series of articles on compensation with this blog on IRS Section 83(b) elections.

A section 83(b) election allows an employee or contractor to include in taxable income the fair market value of property they received for the performance of services before they are truly entitled to that property.  With small businesses, this often occurs with restricted shares granted to employees or contractors that vest over time.  The election does not apply to stock options.

Without the election, with shares that have yet to vest and which the recipient can’t transfer, the fair market value of those shares is included in income when either the shares are theirs or the shares become transferable.  Generally, that means as the shares vest.

The 89(b) election allows the recipient to recognize all the income associated with all the shares at the date of grant, presumably at a lower value.  For tax purposes, all shares are treated as if they are fully vested.

If share value is expected to rise over the vesting period, electing 83(b) is a smart choice.  The election starts the clock for capital gain recognition should the shares be sold or transferred in the future.  It also determines that taxable basis for these shares when later sold or transferred.

Electing 83(b) should not be considered a slam-dunk.   Even with a start-up, shares have value.  This may be influenced by venture capital investments or other equity funding occurring at the same time as the restricted shares grant.  And it is quite possible that when the shares do vest, their value may be lower than at the time of grant.  Lastly, an employee who leaves prior to the completion of the vesting period will have paid taxes on compensation never fully received.

An 83(b) election is smart if the amount of income reported at grant is small, the share value’s growth prospects are moderate to high and the risk of share forfeiture through employee termination is very low.

An 83(b) election must be supported by a valuation of the shares in question.  JBV has significant experience and expertise in that area.

A tax specialist should assist with the election to avoid any tax consequences.

At JBV, we are here to assist you.

Stock Options – Non-Qualified Stock Options and Incentive Stock Options

by | Feb 19, 2016 | All Blog Entries, Corporate, Employee Compensation

Stock options and stock ownership plans are a popular and effective method of incentivizing employees, often at a low cost to both the employer and the employee.  Several types exist, including non-qualified stock options, incentive stock options, employee stock ownership plans, phantom stock, stock appreciation rights and more.  In this first of a series of blog posts, we will look at non-qualified stock options and incentive stock options.

An employee stock option is a contract issued by an employer to an employee to purchase a set amount of shares of company stock at a fixed price for a limited period of time. There are two broad classifications of stock options issued: non-qualified stock options (NSO) and incentive stock options (ISO).  NSOs are typically offered to non-executive employees and outside directors or consultants.  ISOs are reserved for employees, generally executives.  Tax treatment of the two differs as well.

Both plans operate under a vesting schedule.  The employer grants the shares on Day 1 Year 1 but may set a vesting schedule.  Many schedules are based on time: 20% vest at the end of Year 1, an additional 20% at the end of Year 2, etc.  Other vesting schedules are tied to milestones: 20% when sales have reach $15 million, or 20% when productivity reaches 75%.  Both types of vesting schedules need to be clearly documented and agreed to.

Under both plans, no taxes are due at the time of grant.  NSOs are taxed at the date of exercise.  The difference between the Fair Market Value (“FMV”) on the grant date and the FMV on the exercise date is taxed as ordinary income to the recipient and as expense to the company.

ISOs are not taxed when the options are exercised. When the securities are sold, they are taxed under capital gains rules.  If the securities are held for one year after the option exercise and two years after the date of grant, they qualify for long-term capital gain treatment.  If these two qualifications are not met, they are treated as non-qualified stock options and are taxed using ordinary income rates.

An attorney and a tax advisor should design the plan with your guidance to avoid any legal or tax consequences.

At JBV, we have valued many stock option plans, from ESOPs to NSOs to ISOs and more.  We are here to assist you with yours.

What Is Fair Market Value? The IRS v The Taxpayer

by | Nov 20, 2015 | All Blog Entries, Corporate, ESOP, Succession Planning

James and Julie Kress (the “Taxpayers”) filed a lawsuit in United States District Court for the Eastern District of Wisconsin [Case 1:15-cv-01067-WCG] on September 2, 2015. They sought a refund of federal gift taxes and interest they claim were erroneously assessed by the IRS on gifts made in 2007, 2008, and 2009.

The Facts

The Taxpayers are shareholders of an S corporation. The shares are owned by members of the Taxpayers’ family and certain employees and directors. The company’s bylaws and shareholders’ agreement restrict transfer of shares by family members to other family members or to trusts, as defined in the bylaws. An annual valuation opines the value of minority blocks of the shares.

The bylaws and shareholders’ agreement also stipulate transfers of stock by non-family shareholders are subject to a right of first refusal by the company. The bylaws and stockholder agreements specify these transfers must be at 120% of the company’s book value at the time of transfer.

In the years stated above, minority shares were gifted to members of the Taxpayers’ family at Fair Market Value as determined by an independent valuation. These valuations took into account the restrictions on transfers of shares held by family members.

The IRS challenged these amounts. It determined the gifts should have been valued at 120% of book value, the value which the company’s shareholders agreement and by-laws provide for transfers by non-family members.

The Issue

Fair Market Value is defined as the value a property would receive if it were sold in the open market. Among other factors, it assumes the buyer and seller are reasonably knowledgeable about the property in question, they are acting in their own best interest and neither party is under any undue influence.

In this Case, we see two sets of values. One is the values determined by the independent valuations, the other is 120% of book value. The Taxpayers assert the transfer price calculation for non-family members is to simplify transfers. (Shares transferred by non-family members typically had different, and much higher, bases than those transferred between family members).

The Taxpayers claim the restrictions on family transfers are a “bona fide business arrangement.” The restrictions, they claim, were not designed to attain discounted values.

So who is right?

The Taxpayers believe an independent valuation of their company should address the stock restrictions unique to family-owned shares. Because of these restrictions, the value of the shares is heavily discounted. The family contends the restrictions are intended to centralize ownership of the company in the family, not to lower the fair market value of transferred shares.

The IRS has been and is continuing to scrutinize transfers of stock among family members, especially those with high discounts. A perceived goal of the IRS is to prevent businesses from reducing the value of their shares through the imposition of severe restrictions limiting transferability of shares by family members. The IRS claims its valuation at 120% of book value better reflects what an external party would expect to pay for shares. It should be noted employees and directors are not third parties.

This case remains pending.

IRS May Try to Restrict Discounts

by | Jul 27, 2015 | All Blog Entries, Corporate, Employee Compensation, ESOP, Succession Planning

At the American Bar Association (ABA) Section of Taxation meeting on May 8th, 2015, Catherine Hughes, of the Office of Tax Policy in the U.S. Treasury Department, announced that proposed regulations under section 2704(b)(4) could be released before the fall. She indicated that the tax community could look to the Obama Administration’s prior budget proposals on valuation discounts for clues about what the proposed regulations might provide.

Section 2704(b)(4) states:

The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if the such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.

Many believe the IRS does not have the authority to ignore minority and marketability discounts without Congressional action.

The IRS has unsuccessfully tried the Congressional route before.

A proposal was included in President Obama’s budget proposals in each of fiscal years 2010 to 2013. These proposals called for the elimination of discounts in family-controlled entities. None made it to the final approved budget.

Within the last ten years, the Certain Estate Tax Relief Act of 2009 appears to be the sole introduced bill on the topic. (Note my search was unscientific and may exclude other recent actions.)

HR 436: “Certain Estate Tax Relief Act of 2009”

This bill proposed the elimination of the ability to apply discounts for lack of marketability for transfers of “nonbusiness assets” of an entity. “Non-business assets” are those that are “not used in the active conduct of one or more trades or businesses.” For example, the new law would disallow a lack of marketability discount for the transfer of an interest in an entity that relates to the entity’s holdings of marketable securities.

Exceptions would have applied to two particular types of assets. First, an exception would have been made for real property owned by an entity is which the transferor materially participates, which would be measured in a manner similarly to passive activity limitations for income tax purposes. Second, an exception would have existed for “reasonably required” working capital of a trade or business.

Additionally, the Bill disallowed any minority discount for transfers of interests in a family controlled entity. This would have attributed ownership of the transferor to their spouses, parents, children, grandchildren, etc., thus eliminating the minority interest discount.

Status – Died in Congress

Does this mean the current attempt will fail? Who knows! However, panic mode is not called for.