Imagine you’ve spent the past decade pouring your blood, sweat and incapacitated neighbor’s social security checks into your wholly owned C corporation. Your business has evolved into a raging success, and it’s nearly all attributable to your efforts. New clients sign on because of you. Suppliers negotiate on favorable terms because of you. Your corporation has a strong name in the marketplace, and it’s all because of you.
Now the time has come to sell your beloved business, and you and the buyer agree on an asset sale. The purchase price will be $1,000,000 for everything: the inventory, the fixed assets, and the intangible assets, including the trade name and customer list.
In such a fact pattern, determining who is actually selling the intangibles is critical. If the corporation is the seller, the entire purchase price will go into the corporation where it will be subject to two levels of income tax: once when the corporation recognizes a gain on the asset sale, and a second time when the proceeds are distributed and the shareholder recognizes dividend income. Making matters worse, because C corporations do not benefit from a preferential rate on long-term capital gains, all of the corporate level income is taxed at the same rate, reaching a high of 35%.
If, on the other hand, the argument can be made that the shareholder — you — are the owner and seller of the intangible value, well…now we’re getting somewhere. Keeping that cash out of the corporation accomplishes two things. First, the proceeds allocable to the intangibles will only be taxed once; at the individual level. Second, because an individual does benefit from the preferential tax rate afforded long-term capital gains, the proceeds will be taxed at 15%, resulting in as much as a 20% tax savings when compared to the current maximum corporate rate of 35%.
Can it be done? Can an individual shareholder of a corporation be deemed to own — and sell — the intangible assets of a corporation?
The answer is yes, and today the Tax Court added a fourth key authority to the oft-cited triumvirate of Norwalk,[i] Martin Ice Cream,[ii] and MacDonald[iii] by holding in H&M Inc. v. Commissioner,[iv] that when a corporation’s intangible value is entirely attributable to the services of a shareholder/employee, unless the shareholder/employee has effectively transferred the intangible value to the corporation by entering into a covenant not to compete, the shareholder/employee will be deemed to the be the owner of those intangible assets, and is free to sell them in his individual capacity.
In H&M Inc., Harold Schmeets was the sole shareholder of the plaintiff corporation and apparently, the biggest wheel of the North Dakota insurance industry:
Despite the competitive market, Schmeets stood out among insurance agents in the area. He had experience in all insurance lines and all facets of running an insurance agency, including accounting, management, and employee training. He also had experience in a specialized area of insurance called bonding,1 and his agency was the only agency in the area, aside from the bank’s, that did this kind of work. There was convincing testimony that in the area around Harvey no one knew insurance better than Schmeets, and even some of his competitors called him the “King of Insurance.” We also find that when people came to Harvey Insurance to buy insurance, they were buying it from Harold Schmeets, and that he had far more name recognition as an individual than Harvey Insurance did as a firm.
Why anyone would want to give up the prestige that comes with being coined “King of Insurance” in North Dakota is beyond me, but Schmeets eventually decided it was time to sell. He’d had a long-standing relationship with a local bank, and ultimately decided to sell the assets of H&M Inc. to the bank in exchange for $20,000, payable over a period of years.
While Schmeets did not claim to have sold any intangible value directly, he did enter into a compensation package with the bank, as he took over as manager of their insurance practice for a six-year term.
On its tax return for the year of sale, H&M Inc. reported the required amount of the $20,000 proceeds under the installment method. On his personal return, Schmeets reported the compensation income earned for services provided to the buyer.
The IRS, however, took issue with this treatment, arguing that $20,000 was not nearly equal to the fair market value of the acquired assets of H&M Inc., particularly when considering the substantial goodwill created by employing the “King of Insurance.”
Instead, the Service argued that a portion of the compensation payments made by the buyer to Schmeets properly represented additional purchase price for the corporation’s assets. As such, this portion should be taxed first at the corporate level and again when distributed to Schmeets.
Schmeets countered by arguing that like the taxpayers in Martin Ice Cream and MacDonald, he personally owned any intangible value of the corporation. The Tax Court agreed:
The insurance business in Harvey is “extremely personal,” and the development of Harvey Insurance’s business before the sale was due to Schmeets’s ability to form relationships with customers and keep big insurance companies interested in a small insurance market. He grew relationships with large insurance companies that other brokers in the area didn’t.And we specifically find that when customers came to his agency, they came to buy from him–it was his name and his reputation that brought them there. We also find he had no agreement with H & M at the time of its sale that prevented him from taking his relationships, reputation, and skill elsewhere, which was precisely what he did when he began working for the bank’s renamed insurance agency…We therefore find that payments to Schmeets were not disguised purchase price payments to H & M.
What Can We Learn?
There is obviously a significant tax advantage to selling goodwill at the shareholder level as opposed to the corporate level; namely, the advantageous 15% LTCG tax rate and the single level of taxation. In order to successfully argue the position, however, the case law has taught us that certain facts must be present.
Most importantly, the success of the corporation must be directly traceable to the activities, skills, and relationships of the shareholder/employee. But this is only half the battle. In addition, the shareholder/employee must not have entered into a covenant not to compete or long-term employment agreement with the corporation, as this will effectively cause their personal relationships to become property of the corporation.
Lastly, while the Tax Court was lenient in H&M, Inc. with the corporation’s lack of attention to detail when crafting its purchase agreement, future taxpayers may not be so lucky. To safeguard against an IRS attack, a shareholder wishing to take the position that they personally own the intangible value of the corporation should enter into two agreements: one in which the corporation agrees to sell its hard assets, and a second that is entered into directly between the buyer and the shareholder, in which the buyer purchases the intangible assets directly from the shareholder who created them.