Goodwill is defined as the amount by which the purchase price, or consideration transferred, exceeds the net identifiable tangible and intangible assets acquired. For tax purposes, a transaction can create either enterprise goodwill or personal goodwill.
Personal goodwill is the intangible asset attributable to an individual based on their reputation, expertise, relationships, or skills. Personal goodwill offers certain important tax benefits for both the seller and buyer of a business. In a transaction where no personal goodwill exists there is typically double taxation: once at the company level based on any gain created from the sale and once at the selling shareholder level. However, when personal goodwill exists the seller is only taxed once on the sale of that intangible asset to the buyer. In addition, the seller is usually taxed at the long-term capital gains rate as opposed to the ordinary income tax rate.
Below are the requirements for establishing personal goodwill:
- Must prove the existence of personal goodwill
- Must prove personal goodwill has quantifiable value
- Must have been owned by the selling shareholder and transferred to the buyer
There are two commonly used methods for valuing personal goodwill: (i) the with versus without method and (ii) the multi-attribute utility model.
The with versus without method isolates the value of personal goodwill by comparing the cash flows from two scenarios: (i) a scenario where the business operates with the selling shareholder and his/her personal goodwill and (ii) a scenario where the business operates without the selling shareholder and his/her personal goodwill. The difference in the present value of the cash flows from both scenarios represents the value attributable to the personal goodwill.
The multi-attribute utility model is a scoring model where attributes are characterized as either personal or enterprise-level. Personal attributes can include abilities, skills, reputation, and relationships with suppliers and customers. Enterprise attributes can include physical location, marketing and branding, and business reputation. Each attribute is assigned a score weighted by importance. The results of this method bifurcate goodwill between enterprise goodwill and personal goodwill.
