Distinguishing Between Enterprise and Personal Goodwill Reviewed by Momizat on . Why it Matters Distinguishing between enterprise (or business) goodwill and personal (or professional) goodwill can sometimes be difficult. That distinction is Why it Matters Distinguishing between enterprise (or business) goodwill and personal (or professional) goodwill can sometimes be difficult. That distinction is Rating: 0
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Distinguishing Between Enterprise and Personal Goodwill

Why it Matters

Distinguishing between enterprise (or business) goodwill and personal (or professional) goodwill can sometimes be difficult. That distinction is often necessary in marital dissolution and shareholder dispute cases, and when a business is sold. For valuation purposes, the classification is important because prospective buyers will only pay for goodwill that is transferable. In addition, there are tax implications associated with the classification. This article provides an overview of the importance of understanding how to classify goodwill and issues that arise in litigation.

Distinguishing Between Enterprise and Personal Goodwill

When is it Necessary?

Distinguishing between enterprise (or business) goodwill and personal (or professional) goodwill can sometimes be difficult. That distinction is often necessary in marital dissolution and shareholder dispute cases, and when a business is sold. For valuation purposes, the classification is important because prospective buyers will only pay for goodwill that is transferable. In addition, there are tax implications associated with the classification. This article provides an overview of the importance of understanding how to classify goodwill and issues that arise in litigation.

What are the Definitions Associated with Goodwill?

There are many definitions of goodwill. The IRS defines goodwill as “the value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business, or any other factor.”[i] Revenue Ruling 59-60 further states that goodwill is based upon earning capacity, and the value of goodwill “rests upon the excess of net earnings over and above a fair return on the net tangible assets.”[ii] Of course, there may be other intangible assets such as patents or copyrights whose independent value must be subtracted first to arrive at the value of the goodwill.

When we think of personal goodwill, we often associate it with professional occupations such as doctors, attorneys, and accountants, or with personal services like those provided by hair stylists or fitness trainers. But there is usually an element of personal goodwill with any closely held business, especially if there are technical or specialized services provided, but even if that is not the case, the existence of a relatively small number of either clients and/or suppliers may indicate the owner has close personal relationships established with these clients or suppliers.

So how do we distinguish between enterprise and personal goodwill, and how does that impact our valuation of the business? Enterprise goodwill exists regardless of who owns or operates the business and derives from characteristics of the business itself. These can be things such as brand name, website, specialized phone number (1-800-GOT-JUNK), location, logo, specialty technology, secret recipes, and so forth. Personal goodwill exists because of characteristics specific to a particular person; things like reputation, professional knowledge and skills, contacts, and relationships.

One of my colleagues had a case that illustrates how a business typically seen as having mostly personal goodwill can, instead, have mostly enterprise goodwill. It was a marital dissolution case involving a busy dental practice. Although there were only three dentists, the practice was located near a large military installation and in analyzing the client base, nearly all the patients were military personnel on temporary assignment to that air base. So, in this case, the value was largely based on the location of the practice and not the reputations of the individual dentists.

Conversely, in the famous tax court case Martin Ice Cream Company v. Commissioner, the court found that the goodwill was personal to Arnold Strassberg, who was one of the owners of the S corporation, and who had worked in the ice cream distribution business for a long time. Strassberg had both marketing expertise in this field and close relationships with supermarket owners, managers, and buyers. The key to this decision was the absence of any type of employment or non-compete agreement with Martin Ice Cream Company. In this decision, the court stated its long-held position that “personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation.”[iii]

That last caveat is an important distinction. To make the correct determination of how much goodwill belongs to the business and how much to individuals, valuators must determine if non-compete or employment agreements exist, and if so, to what extent they transfer the personal goodwill to the business. Another important distinction—the difference between transferable and non-transferable personal goodwill. As valuators, it is imperative we can make that distinction because as previously noted, no rational buyer would willingly pay for non-transferable goodwill, which will depart along with the person to whom it is attached.

If personal goodwill is only attributable to a person, then how can any part of it be considered transferable if no non-compete or employment agreement exists? There are some forms of personal goodwill that may never be transferable—highly specialized, difficult-to-replicate skills or knowledge, or certain long-term personal relationships, but with a long enough time frame and a well-planned transition from the existing owner to a new owner, it is possible to impart needed knowledge and help build relationships with important clients and suppliers.

Characteristics of Enterprise Goodwill vs. Personal Goodwill

 

Enterprise Goodwill

Personal Goodwill

Customer loyalty

Patronage is based on company-specific factors such as pricing, value, reputation, quality, location, convenience, and unique product or service  offerings; relationships may be contractual

Patronage is based on personal relationships with owners or key employees; few or no contracts with key customers; customers may have many other options for similar goods or services

Employment agreements

Owners and key employees have signed non-compete or other employment agreements with the business

No non-compete or other employment agreements exist between the business and its owners or key employees

Location

Location can be a significant factor in attracting customers

Not a significant factor in obtaining customers/patients

Management structure

Professional management that does not rely heavily on the existing ownership

Existing owners or key employees are crucial to the continued functioning of the business

Marketing

Based on factors integral to the business and individuals are not specifically identified; the business name is separate from its owners; strong brand recognition with the logo prominently featured

Focuses on the owner or a key employee’s reputation, skills, knowledge, contacts or relationships; business name same as the owner(s); marketing features individual’s names and/or photos

Profit allocation

Based on an equitable division of profits or losses

Based on each individual’s production of business income

Reputation and referrals

Reputation is based on the business as a whole; referrals are to the business and not specific individuals; formal referral arrangements may exist

Reputation is based on the owner’s or employee’s personal reputation and not that of the business; referrals are to a specific individual rather than to the business

Sales

Sales are generated by multiple individuals; sales would not drop significantly if any one individual left the business

Highly reliant on the efforts and relationships of an individual; revenue would drop significantly if this individual left the business

Size of the business

Tends to be larger with professional and diverse management; knowledge is institutionalized; there are written policies and procedures

Tends to be smaller with the owner or key individual being integral to the management of the business; knowledge largely resides with a key individual; no or few written policies and procedures

Suppliers

No significant reliance on any one supplier; no one individual handles all transactions with any supplier; relationships may be contractual

Limited number of suppliers and the owner or key employee has personal relationships with the suppliers

Implications for Valuation

In assessing whether personal goodwill exists, the first step is to ascertain if non-compete or other employment agreements exist for owners and key employees. Previous tax court decisions have made it clear that the IRS considers personal goodwill to have been transferred to the business if a non-compete or similar employment agreement exists.[iv] If not, consider how this affects the value. If there is significant personal goodwill present and most buyers would insist on a non-compete from the existing owner(s), consider noting the value both with and without the non-compete or other employment agreement, or assuming a non-compete will be required to sell the business and valuing it accordingly. Your choice will most likely depend on the purpose of the valuation.

If no non-compete or other employment agreements exist for owners and key employees, then go through the factors listed in the previous table to figure out if any personal goodwill exists. If personal goodwill is found to exist, there are a few commonly used methods of determining the value attached to it.

  • Income approach (DCF): With and without method—Estimate the income if the owner or key individual remains with the business vs. if they leave and compare the discounted cash flows. Keep in mind that even the best transition planning will undoubtedly result in some loss of business if the business functions on a large degree of personal goodwill, and some loss of business unrelated to personal goodwill may occur due to changes made by the new owner. Also, consider adjusting the company specific risk between the two scenarios since the degree of reliance on a key individual may be lessened if a good transition plan is in place.
  • Income approach (DCF): Multi-attribute utility model (MUM) method—This method requires identification of the various attributes of personal goodwill, which are then weighted based on two measures: 1) the importance of the attribute to generating cash flow and 2) the degree to which that factor exists.[v]
  • Market approach: Comparable transactions—Search the proprietary databases for sales of similar businesses within the same industry, keeping in mind that the subject business may have more or less reliance on an owner or key individual than the comparable company. Look for those transactions that provide detail for the amounts paid for employment, consulting, and non-compete agreements. These amounts can provide data for determining the value of transferrable personal goodwill based on the theory that the buyer is compensating the seller for the transferrable personal goodwill through these agreements.

These data points should not be the sole point of reference because the amount assigned to these agreements may be based more on tax strategies than on the actual estimated value. Furthermore, the arrangement may include additional compensation that is not captured in the transaction detail. Although it is uncommon, the previous owner may be retained as an employee for a specified period, or much more commonly, certain personal expenses of the former owner may be paid by the business. These can include professional memberships and subscriptions, country club dues, gym memberships, provision of a company car, etc. Therefore, it is wise to compare these values to those generated using one of the income approaches.

Conclusion

The bottom line is there are no hard and fast rules for assessing the value of personal goodwill, but a thorough analysis of the factors previously listed will help in defining what is and is not personal goodwill. My recommendation is to use one of the income approaches listed above and use the market approach as a reasonableness check.

If a valuation is part of a marital dissolution case, you should know the standard for the state in question since there is no consensus from state to state on whether personal goodwill is excluded from the marital assets. The most recent summary I could find indicates that 28 states exclude personal goodwill from marital assets while 12 include it. Mississippi was the only state to exclude all goodwill and Alabama had made no decision. The remaining eight states were either categorized as “complicated,” or they based the inclusion of personal goodwill on the marketability of the personal goodwill, which means segregating transferable personal goodwill from purely personal goodwill will be required.[vi]

[i] Treas. Reg. §1.197-2(b)(1).

[ii] Rev. Rul. 59-60, 1959-1 CB 237.

[iii] 110 T.C. No. 189 (1998).

[iv] Solomon v. Commissioner, T.C. Memo 2008-102 (April 16, 2008), and Howard v. United States of America, U.S. Court of Appeals, Ninth Circuit; 10-36768 (Aug. 29, 2011) affirming 2010-2 USTC.

[v] Webber, Seth, Allocating Goodwill: Learning to Trust the Multi-Attribute Utility Method, https://www.berrydunn.com/uploads/1088/doc/Allocating_Goodwill_Multi_Attribute_Utitlity_Model.pdf [sic].

[vi] BVResources.com, Charting Goodwill Jurisprudence + Map (as of April 2019), https://sub.bvresources.com/FreeDownloads/Goodwill-Hunting-2017.pdf.


Cathy Roper, CPA, ABV, CVA, CFE, CGMA, is an adjunct professor of accounting at Webster University, a long-time financial professional, and has the rare distinction of being an Elijah Watt Sells medalist when she sat for the CPA exam. Her firm, Roper Consulting Group, is based in St. Louis and specializes in business valuations, lost profits, economic damages and other types of forensic accounting services. She also partners with ARA Fraud and Forensics in the prevention and detection of business fraud and the quantification of resulting damages.

Ms. Roper can be contacted at (314) 835-7876 or by e-mail to cathy.roper.cpa@roperconsultinggroup.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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