Separating Personal Goodwill from Entity Goodwill in the Closely Held Company Valuation

Guidance from Bross Trucking v. Commissioner (2014)

Valuation analysts often have to separate company-owned entity goodwill from shareholder-owned personal goodwill in the valuation of closely held companies. These valuations may be performed for family law, shareholder dispute, breach of contract, or other litigation purposes; for transaction structuring and sale consideration allocation purposes; and for gift tax, estate tax, or income tax purposes.

Introduction

Valuation analysts (“analysts”) often have to separate company-owned entity goodwill from shareholder-owned personal goodwill in the valuation of closely held companies.  These valuations may be performed for family law, shareholder dispute, breach of contract, or other litigation purposes; for transaction structuring and sale consideration allocation purposes; and for gift tax, estate tax, or income tax purposes.

The recent U.S. Tax Court decision in Bross Trucking, Inc., et al., v. Commissioner of Internal Revenue¹ (“the Bross Trucking decision”) provides judicial guidance as to the factors analysts should consider in separating company-owned entity goodwill from shareholder-owned personal goodwill in the closely held company valuation.

Based on the judicial guidance provided in the Bross Trucking decision, this discussion considers:

1. the elements that demonstrate the existence of an individual shareholder/employee’s personal goodwill,
2. the factors that differentiate the existence (and transfer) of personal goodwill from the existence (and transfer) of entity goodwill, and
3. the components of the transaction (and of the deal documentation) that indicate the transfer of personal goodwill as part of the overall closely held business sale transaction.

The Bross Trucking Decision

In the Bross Trucking decision, the Tax Court concluded that a trucking company owned by Chester Bross (“Chester”) did not distribute goodwill to Chester who, in turn, did not transfer the goodwill to a newly formed trucking company owned by Chester’s three sons.  Therefore, the Tax Court determined that Chester owed no gift tax with regard to any transfers to LWK Trucking Co., Inc. (LWK) or to his three sons.

Chester created Bross Trucking, a wholly owned company, to haul construction-related materials and equipment for road construction projects.  It is important to note that Chester did not have an employment contract with—and he never signed a noncompete agreement with—Bross Trucking.

About 90 to 95 percent of the Bross Trucking primary customers were companies also owned by Bross family members.  However, Bross Trucking did not have any formal written service agreements with any of its customers.

After facing a series of safety audits and investigations, Bross Trucking was in jeopardy because of heightened scrutiny from both federal and state inspectors.  The company faced the possibility of having its hauling authority revoked.

In response to this negative attention and a possible company shutdown, Bross Trucking ceased its ongoing business operations.  Nonetheless, Bross Trucking remained in existence as a legal entity in order to address any potential regulatory claims and obligations.

To ensure continued trucking services to the various Bross family businesses, Chester’s three sons created LWK.  Chester did not own any interest in LWK.  And, Chester was not involved in managing LWK.

No assets were transferred from Bross Trucking to LWK.  LWK met all of the appropriate regulatory requirements on its own.  However, about 50 percent of the LWK employees had previously worked for Bross Trucking.

Initially, some of the LWK trucks still displayed the Bross Trucking name and logo.  However, the Bross Trucking name and logo actually attracted heightened scrutiny from the inspectors that had investigated Bross Trucking.  Therefore, LWK used magnetic signs to cover up the Bross Trucking names and logos until it could afford to have the trucks repainted.

Chester and his wife did not report any gifts for the year in which LWK began operations.  The Service issued a notice of deficiency to Mr. and Mrs. Bross, claiming:

1. a distribution of corporate intangible assets to Chester, and
2. a subsequent transfer of these intangible assets to the Bross sons.

The principal issues presented before the Tax Court in this matter were whether:

1. any appreciated intangible assets had been distributed by Bross Trucking to Chester, and
2. Chester made a gift of these distributed intangible assets to his sons.

The Tax Court initially determined that the intangible asset being transferred was goodwill.  Goodwill is often defined as the expectation of continued patronage.  The competitive advantage that constitutes goodwill may be represented by a number of property rights or legal interests.

The Tax Court reached the conclusion that there was no distribution of goodwill from Bross Trucking to Chester because it determined a business can only distribute corporate assets, not assets it does not own.  Specifically, a corporation cannot distribute intangible assets owned individually by its shareholders—in this case, Chester.

The Tax Court cited three reasons for this initial determination.

First, the Bross Trucking goodwill was limited to a workforce in place.  At the time, Bross Trucking had lost most of its goodwill and its reputation with its customers because of:

1. its unsatisfactory safety rating,
2. the heightened regulatory scrutiny from safety inspectors, and
3. the possibility of a shutdown of the business operations.

The Tax Court classified these three circumstances as “the antithesis of goodwill.”  This antithesis of goodwill was demonstrated by the LWK need to hide the Bross Trucking name and logo on the LWK trucks.

At the time of the alleged transfer of goodwill, Bross Trucking could not expect any continued patronage.  This was because its customers did not trust it and did not want to continue doing business with it.

The Tax Court recognized that Bross Trucking employed several mechanics and administrative staff.  Bross Trucking may have used this assembled workforce in the corporation and transferred that assembled workforce to Chester.

Second, nearly all the goodwill used by Bross Trucking was part of Chester’s personal assets.  The Bross Trucking established revenue stream, its developed customer base, and the “transparency of the continuing operations” were all a result of Chester’s work in the road construction industry and the personal relationships he had developed.

The Tax Court concluded that a company does not have any entity goodwill when all of the goodwill is attributable solely to an individual shareholder/employee’s personal ability.

Third, Chester did not transfer his personal goodwill to Bross Trucking.  This was partly because Chester did not have an employment contract or a noncompete agreement with the company.  The Tax Court noted that an employer has not received personal goodwill from an employee where that employer does not have a right to the employee’s future services.

The Tax Court concluded that because Chester did not gift the intangible assets to his three sons, he was not required to file a gift tax return.  Because Bross Trucking did not distribute intangible assets to Chester, the Tax Court determined that any remaining issues were moot.

The Elements of the Personal Goodwill

The primary requirement related to personal goodwill is for the business owner to establish that his or her personal goodwill exists separately from any closely held corporation’s entity goodwill.  Personal goodwill is property with a value that is dependent solely on the personal characteristics of the individual business owner.

Although very fact-specific, these personal characteristics can include: the personal relationships, ability, personality, and reputation of the individual shareholder where the company does not have a right by contract or otherwise to that individual’s future services.

In the Bross Trucking decision, Chester, a successful construction businessman, had established close, personal relationships with his primary customers.  Additionally, Chester was extremely knowledgeable about the trucking industry because of his many years of experience.  To that end, customers sought these personal traits through their relationships with Chester, which led directly to business for Bross Trucking.

As a result, the Tax Court concluded that Chester’s personal goodwill existed through these relationships.

Similarly, in the Bross Trucking decision, the Tax Court concluded that any existing goodwill from Chester’s personal relationships was his own personal goodwill.

One factor in the Bross Trucking decision supporting the position that it was Chester’s personal goodwill was that Bross Trucking clearly lacked its own entity goodwill.  Bross Trucking had an impending suspension from various regulatory infractions, causing it to face bankruptcy.  Further, the impending suspension caused customer uncertainty and business interruptions that impaired the company’s business operations.

The Separability of the Personal Goodwill

A second requirement for the existence of personal goodwill is that the individual shareholder possess the right to sell his or her goodwill.  To avoid corporate-level income tax, the personal goodwill employee must be the shareholder’s individual asset.  And, the shareholder cannot have previously transferred that personal goodwill to the corporation.

Personal goodwill is often transferred through shareholder agreements or employment agreements, such as an employment contract or a noncompete agreement.  In general, once such an agreement is in existence, any current goodwill (or any goodwill created thereafter) will likely belong to the employer corporation.

In the Bross Trucking decision, Chester never entered into an employment contract or a noncompete agreement with the company.  Chester was free to leave the company and take his relationships with him if he decided to compete against the business.

As a result, the lack of such agreements allowed the Tax Court to conclude that Chester did not transfer his personal goodwill to the corporate entity.

The Documentation of the Personal Goodwill

While not an issue in the Bross Trucking decision, it is noteworthy that certain formalities and documentation will help support the shareholder’s positions taken with respect to the existence of personal goodwill.

Personal goodwill should be:

1. valued by an independent valuation analyst,
2. clearly identifiable in any purchase transaction agreements, and
3. agreed to by the acquiring party.

Summary and Conclusion

The main issue in the Bross Trucking decision was the Service’s contention that Bross Trucking distributed appreciated intangible assets (including goodwill) to its sole shareholder, Chester Bross.  The Service alleged that Chester then transferred those intangible assets to a newly created trucking entity that his three sons owned.  In holding for Chester, the Tax Court concluded:

1. Bross Trucking had no corporate goodwill at the time of the alleged distribution,
2. Chester’s personal goodwill constituted all of the Bross Trucking goodwill, and
3. Chester did not transfer any of this personal goodwill to the company that he had owned and operated.

Valuation analysts are often asked to identify and quantify the company-owned entity’s goodwill—separately from the shareholder-owned personal goodwill—in the valuation of a closely held company.  These goodwill valuations may be relevant for gift and estate tax, company sale proceeds allocation, and family law and other litigation purposes.  The Bross Trucking decision provides objective guidance with regard to the factors that analysts should consider in such entity versus personal goodwill allocation analyses.

Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a managing director of Willamette Management Associates based in Chicago. His practice includes business valuation, forensic analysis, and financial opinion services. Throughout his notable career, Mr. Reilly has performed a diverse assortment of valuation and economic analyses for an array of varying purposes.   Mr. Reilly is a prolific writer and thought leader who can be reached at: (773) 399-4318, or e-mail to: rfreily@willamette.com.

Note:
1. Bross Trucking, Inc., et al., v. Commissioner of Internal Revenue, T.C. Memorandum decision 2014-107.