Taxation of Goodwill

Client owns an SCorp amd sells assets of the company. Almost all of the sales price is allocated to goodwill.

The goodwill sold here includes client lists of the scorp, licenses held, lease agreements, and the value of the operations but does not include personal goodwill of the seller.

Doing some research I see a lot of tax preparers writing articles to call this short term capital gain. I also see a lot of tax preparers writing articles that call it long term capital gain.

The authoritative research I found just calls it a capital asset. Not sure on holding period if its created the day of sale or when the assets were originally developed in house. Also not sure if it varies depending on how the goodwill arose. None of the goodwill was purchased by the seller.

Any advice?

Petitioner reported the gain of $2,599.06 realized in 1956 upon the receipt of the first payment made under the contract providing for the sale of his public accounting practice as long-term capital gain from the sale of goodwill. Respondent increased petitioner's taxable income on the ground that the gain realized constituted the assignment of a share in future earnings of the partnership and is taxable as ordinary income.
~Watson v. Commissioner, 35 T.C. 203 (1960)

The Howards filed a 2002 federal income tax return and reported $320,358 as long-term capital gain income resulting from the sale of goodwill to Finn Corporation (Ct. Rec. 1 at 2). An Internal Revenue Service ("IRS") audit of Dr. Howard's 2002 return resulted in the IRS recharacterizing the sale of the goodwill as a corporate asset and treating the amount received by Dr. and Ms. Howard from the sale to Finn Corporation as a dividend from Dr. Howard's professional service corporation in the amount of $320,358 (Ct. Rec. 1 at 3).
~Howard v. U.S., No. CV-08-365-RMP. (2010)

Clearly, goodwill is not an asset that springs into existence as soon as the business is sold.

I would start the holding period on the day the business acquires its first customer, since that is the first day the business could reasonably hold an "expectation of continued public patronage".

Thanks for the response, Chay. The two cases you cite appear to be against the treatment of long term capital gains.

I know theres a difference between business goodwill and personal goodwill. I think in my clients case it's all business goodwill. She is in hospitality and sold a hotel, and she herself carries no reputation so I dont see anything being reallocated as personal goodwill.

The goodwill sold is a capital asset. That much I can say for certain.

I see the argument that the operations have been around since the business was formed, but I also see the argument that the IRS wouldn't consider recognize the assets existence until it became a 197 intangible, which happened on the date of the sale.

We are talking about 4 million allocated to goodwill so the long term vs short term treatment is significant and I dont want to file this return with some authority.

I also see the argument that the IRS wouldn't consider recognize the assets existence until it became a 197 intangible, which happened on the date of the sale.

Then you should ask yourself why the IRS did not attempt to use this argument in the two cases I cited.

In numerous cases, the courts have agreed with the parties’ treatment of gain from the sale of goodwill as a long-term capital gain. One case where the Tax Court actually ruled that it was long-term capital gain is Drybrough, 45 T.C. 424 (1966).
https://scholar.google.com/scholar_case ... i=scholarr

It follows that in our view the white files were a single intangible mass asset in the nature of goodwill and that the gain attributable thereto ($395,000 less petitioner's unrecovered cost basis of $25,444.15) is long-term capital gain.

But can we respect an opinion that says

When a delinquent account was sent in by a manufacturer for collection, the claim became the subject of a white file, so-called because the papers relating to the claim were kept in a white manila folder.

Yes, we can. "White manila folder" was not meant as a contradictory term. The same paragraph explains that a “white manila folder” was a folder that was kept inside of a “white file jacket.” The taxpayer also had “green files” and “gold files,” and the Tax Court referred to the “green files” as “papers in green manila folders,” which I suspect were manila folders kept inside of a green file jacket.

Petitioner reported the gain of $2,599.06 realized in 1956 upon the receipt of the first payment made under the contract providing for the sale of his public accounting practice as long-term capital gain from the sale of goodwill. Respondent [the Commissioner of Internal Revenue] increased petitioner's taxable income on the ground that the gain realized constituted the assignment of a share in future earnings of the partnership and is taxable as ordinary income.
~Watson v. Commissioner, 35 T.C. 203 (1960)

"Respondent" means the IRS -- not the Tax Court. The Court did not rule that the gain was ordinary income. The Court ruled that the gain was a capital gain. Read the last sentence of the text:

We [the Tax Court] find that the consideration paid was for the goodwill of Watson's practice and the gain realized therefrom is taxable as capital gain.

The Howards filed a 2002 federal income tax return and reported $320,358 as long-term capital gain income resulting from the sale of goodwill to Finn Corporation (Ct. Rec. 1 at 2). An Internal Revenue Service ("IRS") audit of Dr. Howard's 2002 return resulted in the IRS recharacterizing the sale of the goodwill as a corporate asset and treating the amount received by Dr. and Ms. Howard from the sale to Finn Corporation as a dividend from Dr. Howard's professional service corporation in the amount of $320,358 (Ct. Rec. 1 at 3).
~Howard v. U.S., No. CV-08-365-RMP. (2010)

The Howard citation is incomplete. When citing to a court decision, we need to identify not only the parties and the date, but also the court. The case number in this case is of little help in locating the text of the decision.

And, nothing in this quote indicates what the Court ruled. The IRS concluded something in an audit. The questions are: Who won in court? The taxpayer or the IRS? What was the court decision?

I did some digging. The text of the Howard decision is found at Howard v. United States, no. cv-08-365-RMP, U.S. District Court for the Eastern District of Washington (July 30, 2010).

I only skimmed the text. The taxpayers lost, but the main issue on which they lost had to do with whether the goodwill was a personal asset or, alternatively, an asset of their corporation. The IRS contended that on the facts of that case, the goodwill was an asset of the corporation. The Court ruled in favor of the IRS:

Bound by the covenant not to compete with Howard Corporation for a period of three years beyond when Dr. Howard no longer held Howard Corporation stock, which was until the dissolution of the Howard Corporation at the end of 2003 (see Ct. Rec. 28, Ex A at 28), Dr. Howard could not have earned income from a competitive dental practice within fifty miles of Spokane (Ct. Rec. 28, Ex F). Therefore, even if the goodwill had belonged to Dr. Howard personally, it likely would have little value, because Dr. Howard could not have practiced within a fifty mile radius from his previous practice location for at least three years beyond the date of the Howard Corporation dissolution. Those prohibitions would likely discourage patients from following Dr. Howard to a new location.

Therefore, the Court finds that the goodwill is a corporate asset of Howard Corporation. The Court further finds that the Howards are not entitled to the refund that they seek for the 2002 tax year.

Thanks for the response, Chay. The two cases you cite appear to be against the treatment of long term capital gains.

As noted above, in the Watson case, the Court ruled exactly the opposite. The Howard case does not stand for that proposition, either.

"Respondent" means the IRS -- not the Tax Court. The Court did not rule that the gain was ordinary income. The Court ruled that the gain was a capital gain.

I don't think anyone's confused about the meaning of "Respondent". Also, we aren't interested in what the court ruled in this case.

What we are interested in is whether the IRS would contest long-term capital gain treatment when proceeds are allocated to goodwill. The snippets I posted from the cases are sufficient to illustrate that they would not. When the IRS makes an argument, it's that the proceeds aren't allocated to goodwill in the first place.

The case number in this case is of little help in locating the text of the decision.

Wrong. When I google "No. CV–08–365–RMP", the text of the Howard case is the first result.

And, nothing in this quote indicates what the Court ruled. The IRS concluded something in an audit. The questions are: Who won in court? The taxpayer or the IRS? What was the court decision?

No, those aren't the questions. The question is: How is the holding period for goodwill determined? Like I said, the quotes are sufficient to illustrate that the IRS doesn't contest long-term capital gain treatment, which answers the question to the extent necessary for the OP's purposes. Your questions are irrelevant because the issue in this thread was never raised in court.

"Respondent" means the IRS -- not the Tax Court. The Court did not rule that the gain was ordinary income. The Court ruled that the gain was a capital gain.

I don't think anyone's confused about the meaning of "Respondent". Also, we aren't interested in what the court ruled in this case.

Well, you may not be interested, but my impression is that a poster here misinterpreted what the courts ruled in both cited cases. That's why I added the clarification.

What we are interested in is whether the IRS would contest long-term capital gain treatment when proceeds are allocated to goodwill. The snippets I posted from the cases are sufficient to illustrate that they would not. When the IRS makes an argument, it's that the proceeds aren't allocated to goodwill in the first place.

Just about everyone is interested in what the IRS position might be on a given issue. Ultimately, however, as a tax practitioner, I am interested in what the tax law is. I want to know what happens if the matter is contested in court.

The case number in this case is of little help in locating the text of the decision.

Wrong. When I google "No. CV–08–365–RMP", the text of the Howard case is the first result.

Congratulations. I got the same quick result immediately, using google by excerpting a portion of the quoted text of Howard.

Nevertheless, when citing to a court decision, we should cite the decision properly. We shouldn't have to google a case number (or google an excerpt from the quoted text) just to determine something as basic as the identity of the court that made the decision.

And, nothing in this quote indicates what the Court ruled. The IRS concluded something in an audit. The questions are: Who won in court? The taxpayer or the IRS? What was the court decision?

No, those aren't the questions. The question is: How is the holding period for goodwill determined? Like I said, the quotes are sufficient to illustrate that the IRS doesn't contest long-term capital gain treatment, which answers the question to the extent necessary for the OP's purposes. Your questions are irrelevant.

I haven't posed any "questions", relevant or otherwise. A poster stated: "The two cases you cite appear to be against the treatment of long term capital gains." That was an incorrect conclusion about those two cases. I provided the corrections.

If we're going to insert quotes from texts, we need to be clear about the sources of the quotes and, in the case of court opinions, we need avoid making incorrect conclusions about what the courts ruled.

EDIT: On second thought, I concede that I did pose some questions, but again the questions seemed to need to be answered based on what I understood to be the poster's conclusions.

I ended up reading the court cases myself (google isnt great for me and I too had to google the excerpt as the case number wasn't getting good hits)

Agree that the excerpts provided are very very misleading.

I care more about getting it right, despite what the IRS might say. One case wasn't really on point IMO, but but I think I have something to go on to justify LTCG treatment and sleep easy that night.

Thank you all for your responses.

my impression is that a poster here misinterpreted what the courts ruled in both cited cases

Yes, that was my impression as well. My response was to point out, in post #4, that the IRS didn't even raise the issue that the poster thought was decided in favor of the IRS. I thought about diving into details like you did, but decided it wasn't necessary.

I want to know what happens if the matter is contested in court.

Me too. However, in this case, I don't think we'll find the matter contested in court. The best we can do is look at rulings where long-term capital gain treatment of gain from the sale of goodwill was not contested. Dave brought up a much better example of this than I did. Here's a very illustrative quote from the Drybrough case that he cited:

Respondent has conceded on brief that any "surplus" amount (now held to be $78,573.60) assigned to this item by the agreement may be taxed to petitioner, in installments, on the long-term capital gain basis as if paid for goodwill.

Based only on this quote, we have no idea what the court's decision was, or indeed, what the issue of controversy even was. But that doesn't matter, because we still have an understanding of how the court, the IRS, and the petitioners view the treatment of gain on the sale of goodwill.

Agree that the excerpts provided are very very misleading.

The IRS doesn't contest long-term capital gain treatment. If they did, they would have raised the issue. They didn't. I don't understand what's misleading about that.

but I also see the argument that the IRS wouldn't consider recognize the assets existence until it became a 197 intangible, which happened on the date of the sale.

Your thought process isn’t quite right. Sec 197 is a deduction/capitalization provision for starters. You can see where it’s situated in the Code. Thus, it mainly impacts buyers. The only part of 197 that affects sellers is 197(f), which doesn’t apply to your goodwill. (There’s another provision in Sec 1245 pertaining to Sec 197, but that doesn’t apply to your goodwill either). The issue here is one of holding period – LT or ST. We need to know when that “holding period” starts. Chay’s answer is as good as it’s gonna get, since we’re dealing with a self-created asset. We are not concerned about the fluctuations in value to that existing asset and when those fluctuations occurred. We are concerned about when the asset was first created, when it first existed and sprang into being. If that was over 1-year ago, you’re good to go with LT treatment.

From Charles H. Girt, TC Memo 1961-286, 10/16/1961

Our interpretation of the agreement is that there was the sale of an existing practice which Girt had built up over a period of some 15 years. We consider it immaterial whether any of the individual agreements were entered into less than six months before the sale. The petitioner is entitled to treat the proceeds as long-term capital gains.

Also see this case:

ERWIN D. FRIEDLAENDER., 26 TC 1005, 09/11/1956

And as to this comment:

We are talking about 4 million allocated to goodwill so the long term vs short term treatment is significant and I dont want to file this return with some authority.

That $4m self-created asset didn’t first spring into being within the past 1-year. It’s a safe bet that this client has operated this business for quite some time (you can let us know about that)…In fact, this S-corp is probably his biggest personal asset.

Is there a bright line in the tax law? No. It comes down to being able to prove that the goodwill first existed more than 1-year ago. If the business has been around for a while, LT treatment won’t be questioned by the IRS because they know it’s a losing argument.

Goodwill is ordinary income to the extent you may have received an ordinary deduction for it previously. The example of that is you purchase a tax/accounting practice more than 15 years ago now and amortized it to 0 (or whatever amount) if you sell "it" you have ordinary income to the extent of the amortization taken and capital gain for the any excess over that. Do not ask me about splitting of sale between those purchased and amortized and those not - you may want to do that..