Key takeaways
- Goodwill is the value of a business beyond its identifiable tangible and intangible assets. It can be split into enterprise goodwill, which belongs to the business, and personal goodwill, which belongs to an individual.
- Personal goodwill arises from an individual’s skills, reputation and relationships, and generally cannot be transferred without that person’s cooperation, such as a non-compete or transition agreement.
- In a C corporation asset sale, properly documented personal goodwill sold directly by the owner may avoid a second layer of corporate tax.
- In divorce, many states treat personal goodwill as a non-divisible personal attribute, while enterprise goodwill is a divisible marital asset. State law varies.
- Separating the two requires careful analysis and documentation. Courts and the IRS look at substance, including existing non-compete and employment agreements.
A dental practice sells for $2 million. Equipment and supplies are worth $300,000. The remaining $1.7 million is goodwill. But whose goodwill is it?
Some patients come because the practice is conveniently located, has an established name, accepts their insurance and runs efficiently. Others come because they have trusted the dentist for twenty years and would follow her anywhere.
The first kind of value belongs to the practice. The second belongs to the dentist. That distinction, between enterprise goodwill and personal goodwill, can significantly affect how a sale is taxed, how a marital estate is divided, and how a buyer prices a deal.
What goodwill is
In valuation, goodwill generally represents the value of a business in excess of its identifiable net assets: the expectation that customers will keep coming back and that the business will continue to generate returns above what its tangible assets alone would produce.
Goodwill is closely related to other intangible assets, such as customer relationships, trade names, workforce, and processes, which may be identified and valued separately depending on the purpose of the valuation. See our article on valuing intangible assets and intellectual property.
Enterprise goodwill
Enterprise (or practice/commercial) goodwill is attributable to the business itself. It would stay with the business if the owner left. It is created by factors like:
- brand and trade name recognition;
- location and visibility;
- established systems, processes and technology;
- trained workforce and management team;
- contracts, payor relationships and vendor agreements;
- phone numbers, websites and marketing assets; and
- a diversified, institutional customer base.
Enterprise goodwill is generally transferable and saleable without the owner’s personal participation.
Personal goodwill
Personal (or professional) goodwill is attributable to an individual’s personal attributes, such as:
- professional skill, expertise and reputation;
- personal relationships with clients, referral sources and key customers;
- personal ability to generate business; and
- knowledge and credentials tied to the individual.
Personal goodwill generally cannot be transferred unless the individual agrees to help transfer it, through a non-compete agreement, transition services or ongoing involvement, and even then the transfer may be imperfect.
Personal goodwill is most common in: – professional practices (medical, dental, veterinary, legal, accounting, engineering); – small owner-operated businesses with relationship-driven sales; – consulting and creative businesses; and – businesses where the owner is the “face” of the company.
See our article on valuing a professional practice for practice-specific considerations.
How valuators separate personal and enterprise goodwill
There is no single formula. Analysts typically consider several methods and the specific facts.
1. Multi-attribute (factor) analysis
The analyst weighs factors suggesting personal versus enterprise goodwill, such as:
| Points to personal goodwill | Points to enterprise goodwill |
|---|---|
| Owner personally generates most revenue | Revenue generated by multiple professionals or staff |
| Clients identify with the owner | Clients identify with the brand |
| Owner’s specialized skills are hard to replace | Systems and processes are documented and transferable |
| Few written contracts | Long-term contracts, recurring revenue |
| Small staff, limited management | Deep management team |
| Referral relationships are personal | Marketing-driven customer acquisition |
| Owner has no non-compete with the company | Owner is bound by a non-compete with the company |
2. “With and without” method
The analyst estimates the business’s cash flows with the owner (or with a non-compete in place) and without the owner (assuming the owner leaves and competes). The present value of the difference, adjusted for the probability and impact of competition, indicates the value attributable to the individual.
3. Non-compete analysis
Because personal goodwill is often transferred through a non-compete, the analyst may assess what the business would lose if the owner competed, and over what period.
4. Market evidence
Transactions in which buyers paid separately for an owner’s non-compete, transition or personal goodwill can provide support.
Example
A practice has total goodwill of $1,500,000. After a multi-attribute analysis and a with-and-without model, the analyst concludes that approximately 60% is attributable to the owner’s personal relationships and reputation:
- Personal goodwill: $900,000
- Enterprise goodwill: $600,000
The conclusion must be supported by the facts and documentation, not chosen to achieve a desired tax or legal outcome.
Why it matters #1: C corporation asset sales
When a C corporation sells its assets, gain is taxed at the corporate level. When the proceeds are distributed to shareholders, they may be taxed again as dividends or liquidating distributions. This double taxation can significantly reduce the owner’s net proceeds.
If part of the value is the owner’s personal goodwill, the owner may be able to sell that personal goodwill directly to the buyer, generally producing long-term capital gain at the individual level without the corporate-level tax on that portion.
Key court cases
- Martin Ice Cream Co. v. Commissioner (1998): The Tax Court recognized that a shareholder’s personal relationships with key suppliers and customers were his personal assets, not corporate assets, in part because he had no employment or non-compete agreement with the corporation.
- Norwalk v. Commissioner (1998): The Tax Court found that the goodwill of an accounting practice belonged largely to the individual accountants, who had no enforceable non-competes with the corporation.
- H&M, Inc. v. Commissioner (2012): The Tax Court recognized personal goodwill belonging to the owner of an insurance agency.
- Howard v. United States (2010, aff’d 2011): A dentist who had an employment agreement and covenant not to compete with his own professional corporation could not treat goodwill as personal; the court held it belonged to the corporation.
Lessons from the cases
To support a personal goodwill sale: – the owner generally should not have an existing non-compete or employment agreement that transfers his or her relationships to the company; – the personal goodwill should be separately identified and valued by an independent appraiser; – there should be a separate purchase agreement between the buyer and the owner for the personal goodwill; and – the allocation should be consistent across the purchase agreement, IRS Form 8594 and tax returns.
Planning should happen before the letter of intent, with tax counsel involved. See also our article on asset sale vs. stock sale and purchase price allocation.
Why it matters #2: divorce
When a business or professional practice is part of a marital estate, the treatment of goodwill can significantly affect the outcome.
- Many states distinguish between enterprise goodwill, which is treated as a divisible marital asset, and personal goodwill, which is treated as a personal attribute of the owner spouse and not divisible. The reasoning is that personal goodwill reflects the owner’s future earning capacity, which may already be considered in support awards.
- Some states include both types of goodwill in the marital estate, and a few exclude goodwill more broadly.
- The standard of value used in divorce, whether fair market value, fair value or “value to the holder,” also influences how goodwill is treated.
Because the law differs by state and evolves through case law, the valuation analyst must work closely with the family law attorney to apply the correct framework. Our article on business valuation in divorce covers this process.
Why it matters #3: deal pricing and structure
Even outside tax and divorce, buyers care about personal goodwill because it may leave with the seller. Significant personal goodwill can lead buyers to: – reduce the price; – require a longer transition period; – negotiate non-compete and non-solicitation agreements; – shift part of the price into an earnout or consulting agreement; or – seek retention agreements with key employees.
Reducing owner dependence before a sale can convert personal goodwill into enterprise goodwill, and increase value. See our article on key person risk.
How owners can build enterprise goodwill
- Institutionalize client relationships by introducing other team members.
- Document systems and processes.
- Develop a management team that can operate without the owner.
- Build the brand separately from the owner’s personal name where possible.
- Formalize contracts and recurring revenue arrangements.
- Diversify referral sources.
Frequently asked questions
The double-tax benefit is most significant for C corporations. For pass-through entities, the classification can still affect character of income, allocation and other planning issues. Discuss with a tax advisor.
No. A non-compete payment is generally taxed as ordinary income to the recipient and amortized by the buyer. Personal goodwill sold as a capital asset is treated differently. The two must be supported separately.
Not necessarily. It depends on the facts. Businesses with strong systems, brand and management may have mostly enterprise goodwill.
A credentialed, independent valuation professional with experience in the relevant purpose, such as tax, divorce or transactions.
The bottom line
Goodwill is not a single asset. Separating personal from enterprise goodwill is a fact-intensive analysis that can change who pays tax, how a marital estate is divided, and what a buyer is willing to pay. The analysis must be independent, well-supported and consistent with the legal framework that applies.
Foxboro Consulting Group, Inc. provides business valuations and litigation support, including goodwill allocations for transactions, tax planning and marital dissolution. Contact us to discuss your situation.
This article is for general informational purposes and does not constitute legal, tax or valuation advice. Case outcomes depend on specific facts; consult qualified tax and legal counsel.
