With apologies to the movie of a similar name, the hunt for personal goodwill in an agency sale context may provide agency owners with a winning tax saving strategy.

As an agency owner considers the prospects of selling it’s important to recognize that most buyers want to purchase assets because of their ability to create tax basis in the assets acquired, and to then be able to depreciate and/or amortize these assets. Arguably, the most important assets sold by property-casualty agencies are “expirations.” These assets are deemed to be a Section 197 Intangible Asset and are amortized over 15 years under the tax code by the purchaser. If the selling agency is a C corporation the prospect of paying a double tax under an asset sale are great in that the gain upon the sale of all assets will be taxed first at the corporate level, and then at the shareholder level. It is not unusual to see tax rates in excess of 50% under this scenario.

How can an allocation of the purchase price to personal goodwill save taxes? In its simplest form, an allocation of a portion of an agency’s sale price to personal goodwill will result in capital gains treatment to the selling owner; as the owner will receive these dollars directly and be taxed at capital gains rates approximating 20%. The IRS, in various revenue rulings, has recognized the existence of personal goodwill and the tax court has supported the notion that under certain circumstances a company or agency cannot sell an asset it does not own or control.

But what exactly is personal goodwill? Personal goodwill, as differentiated from “enterprise” or “business” goodwill is an intangible asset that has certain economic characteristics and value that is directly attributable to an individual. Among the characteristics most cited are reputation, specialized skill or knowledge, personal relationships, experience, level of success style, etc. that provides a business a level of intrinsic value. It is distinguishable in that its value rests with the individual, and if not purchased or contracted for in a purchase agreement, can walk out the door after the sale is completed. In many instances the owner of an agency, having the close relationships with the agency’s customers and being the leading producer, essentially has created, nurtured and “owns” all or a portion of the goodwill of an agency.

So under what conditions does an allocation to personal goodwill make sense? Agencies organized as a C corporation and under some circumstances S corporations—where the sale of assets by the agency will result in a double tax—are the most likely candidates for an allocation to personal goodwill. However, if an employment agreement or non-piracy agreement is in existence between the owner and the agency an allocation to personal goodwill is unlikely to be sustained.

The strategy can also be helpful in situations where two or more agency owners desire to have a special allocation to one of the owners. Normally special allocations of sale proceeds cannot be made without tax consequences. One situation comes to mind—two equal agency owners wanted to sell their agency, but recognized that one shareholder should receive a higher proportion of the sales price. After a review of the fact pattern, a scheme was agreed on by both the buyer and the sellers to allocate a portion of the sales price to the personal goodwill of one of the selling owners. It’s important to note that the IRS and the courts have indicated that in order for personal goodwill to be sold it must be accompanied with a covenant not to compete. This makes intuitive sense from a buyer’s perspective. How can you protect the very goodwill being purchased without a covenant not to compete?

Agency owners considering a sale need to determine if a non-compete or other agreement exists that would short circuit any attempt at an allocation to personal goodwill. The next step is the identification of the assets being sold and the relationship of the owner(s) to the agency. In most cases, the most significant asset of the agency will be its expirations. If it is shown that the owner(s) have a significant role in the creation and maintenance of expirations, the next step is an independent appraisal of the assets being sold—including both the expirations and goodwill.

The more difficult part of the valuation process will be the allocation between personal and enterprise goodwill. Each case by its very nature will be different, however a critical assessment and analysis is necessary of the attributes that would influence such an allocation. The appraisal will most likely be performed by a valuation analyst experienced in the allocation of goodwill into its component parts. The allocation road for an agency owner is not without its challenges but the rewards can be very significant.

Edward Pratesi (edp@kpco-cpa.com) is managing director at Brentmore Valuation Advisors, LLC in Farmington, Conn.