By Larry S. Blair, CPA, JD, and Leilani Medina Costa, CPA, JD
Businesses often have various types of intangible assets that enhance their value. But any time there is a transaction involving these intangible assets, subtle, yet significant, tax considerations may arise. The gain on the sale of an intangible asset will generally qualify for the current 15 percent long-term capital gain tax rate. The business acquirer will generally qualify for a 15-year, straight-line amortization of this purchased asset. Where the entity is a limited liability corporation treated as a partnership or an S corporation, the sale of assets by the entity does not generally create a particular tax problem as the gain would flow through to the individual and be subject to one level of tax.
However, there are unique circumstances where this flow-through does not occur, creating a double taxation on a particular transaction. When planning a corporate transaction that involves intangible assets, be sure to determine the ownership and the valuation impact of intangible assets that may be sold. The following cases may provide guidance surrounding the sale and ownership of intangible assets.
In 1991, the Florida Supreme Court decided the case of Thompson vs. Thompson,1 which involved professional goodwill when valuing a law practice in a divorce settlement. In this case, the husband was the sole shareholder of a law practice. The wife took the position that professional goodwill was a marital asset that should be included in the marital estate. The court held that for professional goodwill to be marital property, it must be a business asset that has value independent of the continued presence or reputation of any individual. Thus, professional goodwill was not considered when valuing the husband’s law practice.
In 1998, the U.S. Tax Court decided the case of Martin Ice Cream Company.2 This revolved around a complicated sale of assets and what was ultimately determined to be a failed IRC §355 split-off. The case reviewed the personal relationships developed by an owner/employee over the years. The IRS took the position that this intangible asset was owned by the corporate entity; therefore it generated a corporate-level tax when the intangible assets were sold. The Tax Court held that the personal relationships of the owner/employee were not corporate assets since the owner had no employment contract with the corporation. These personal assets were considered entirely distinct from the intangible asset of corporate goodwill. Thus, the sale of personal goodwill by the individual was recognized and upheld.
Also in 1998, the U.S. Tax Court decided the case of William Norwalk,3 involving the liquidation of an accounting firm. The IRS contended that when the corporation was liquidated, it distributed customer-based intangibles to its shareholders, thus generating a corporate-level tax. The IRS took the position that these intangible assets were corporate assets that had specific value. The taxpayers maintained that the corporation did not own the intangibles. Rather, they argued, the accountants themselves owned the intangibles, and as such there was no transfer nor any corresponding taxable gain attributed to the intangibles. The court held that there was no saleable goodwill in this case because the business of the corporation is dependent upon its key employees, unless they enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships become the property of the corporation. In reviewing these three cases, and others related to this issue, it is clear that there are significant planning opportunities and potential pitfalls when dealing with customer-based intangibles. For instance, a valuable personal asset could have become a corporate intangible asset had an employee/owner entered into an employment agreement, dramatically affecting property settlements and tax liability.
When significant value may involve customer-based intangibles, understand who is the owner of the intangible asset. When dealing with the sale of assets by a C corporation or an S corporation that may have built-in gains, the determination of asset ownership provides a significant planning opportunity. If the owner/employee owns the intangible asset, it is appropriate to document and allocate a portion of the purchase price to the intangible assets owned by the individual. This allocation planning would create only one level of tax at a long-term capital gain rate at the individual level, avoiding the double taxation at the corporate and individual levels.
1 Thompson v. Thompson, 576 SO.2nd (267)
2 Martin Ice Cream Company v. Commission, 110 T.C. No. 18, 110 T.C. 189
3 Norwalk v. Commission, T.C. memo 1998-279
Larry S. Blair, CPA, JD, is a partner with the law firm of Metz Lewis LLC in Pittsburgh, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at lblair@metzlewis.com.
Leilani Medina Costa, CPA, JD, is an attorney with Metz Lewis. She can be reached at lcosta@metzlewis.com.
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