When a professional corporation sells its assets or liquidates, one important tax issue is whether the corporation or the shareholder-employees own any appreciated professional goodwill.
For tax purposes, goodwill is an intangible asset. It represents the value of a trade or business based on expected continued customer patronage due to its name, reputation, and similar factors.
When valuable professional goodwill does not show up on the corporate balance sheet, it can often be overlooked when evaluating the tax impact of liquidating the corporation. That could be a big mistake.
Why It Matters
When a professional C corporation is determined to own valuable goodwill that has little or no tax basis, selling the corporation’s assets (including the goodwill) or liquidating the corporation can trigger double taxation. On the other hand, if the shareholder-employees are determined to own the goodwill, the value of that goodwill will not be exposed to double taxation. This means that corporate ownership of professional goodwill is detrimental, while shareholder ownership of professional goodwill is beneficial.
The following two examples illustrate the point.
Example 1: Professional C Corporation Owns the Goodwill
Let’s say you and your business partner are equal shareholders of a professional C corporation we’ll call ABC Corp. After some serious disagreements about the future of the business, you and your partner decide to liquidate the corporation and go your separate ways. Assume you each have basis of $50,000 in your ABC Corp shares, which you have held for many years.
Immediately before the liquidation, ABC Corp owned two assets:
1. Cash of $500,000.
2. Goodwill with fair market value of $1 million and tax basis of zero.
Upon liquidation, ABC Corp is deemed to sell its assets for FMV. Therefore, the corporation must recognize a $1 million corporate-level taxable gain on the deemed sale of the appreciated professional goodwill. Assume the corporate-level federal income tax hit is $340,000 (34 percent of the $1 million gain. In this analysis, we will ignore any state taxes).
ABC Corp pays the $340,000 tax bill and distributes the remaining cash of $160,000 ($500,000 minus $340,000 lost to taxes) and the goodwill worth $1 million to you and your partner in a complete liquidation.
You each receive liquidation proceeds of $580,000 ($80,000 of cash plus $500,000 of goodwill) in exchange for turning in your stock. These exchanges are treated as garden-variety stock sales. Therefore, you and your partner must each recognize a $530,000 long-term capital gain (stock sale proceeds of $580,000 minus $50,000 tax basis in the shares). If the liquidation occurs in 2014, each shareholder could owe the IRS up to $106,000 (20 percent times $530,000) for a combined total of $212,000. Plus, the entire gain could potentially get hit the 3.8 percent Medicare surtax. If so, that would add another $40,280 to the tax bill.
That would bring the overall federal income tax bill from liquidating ABC Corp up to $592,280!
Example 2: Shareholder-Employees Own the Goodwill
Same basic facts as in Example 1, except this time assume that it is determined that you and your business partner, rather than ABC Corp, own the professional goodwill.
There is no corporate-level tax liability from liquidating ABC Corp because it doesn’t own any appreciated assets.
You and your partner each receive cash liquidation proceeds of $250,000 in exchange for turning in your stock. These exchanges are treated as regular stock sales. Therefore, you and your partner must each recognize a $200,000 long-term capital gain (stock sale proceeds of $250,000 minus $50,000 tax basis in the shares). If the liquidation occurs in 2014, each shareholder could owe the IRS up to $40,000 (20 percent times $200,000) for a combined total of $80,000. You could also owe up to a combined $15,200 for the 3.8 percent Medicare surtax.
Therefore, the overall maximum federal income tax cost of liquidating ABC Corp would be $95,200. Compare this to the $592,280 tax cost in Example 1 where the corporation was determined to own the professional goodwill. The entire tax difference is solely due to the difference in who owns the professional goodwill.
To make a convincing argument that goodwill is owned by the shareholder-employees rather than the corporation, consider explicitly terminating any employment agreements and noncompete agreements as far in advance of the corporation’s sale of assets or liquidation as possible. Consult with Filler & Associates and your attorney about your situation.