In an unpublished decision regarding taxation of the “goodwill” upon the sale of a company, the Ninth Circuit recently ruled that while professional personal relationships are generally not corporate assets, such relationships can become corporate assets if the employee has an employment contract or covenant not to compete with the corporation, which would render the value of the “goodwill” a corporate dividend instead of a personal asset. 

In Howard v. United States [pdf], a dentist sold a dental practice.  He maintained that the goodwill proceeds from the sale of the practice were personal assets subject to federal income taxation as long-term capital gain.  The government, on the other hand, argued that the goodwill proceeds belonged to the appellants’ professional service corporation and therefore, the International Revenue Service properly re-characterized the proceeds as a dividend payment. 

The court sided with the IRS.  It found significant that the dentist worked for his professional dental corporation pursuant to an express employment contract by which he agreed “to practice dentistry solely as an employee of the Corporation and . . . devote his entire professional time to the affairs of the Corporation.”  Under this agreement, the corporation retained “complete control and authority” with respect to all clients, files and records, and the appellant also agreed not to compete with the corporation for a set number of years.  The court reasoned that although the relationships that the dentist developed with his patients may be accurately described as personal, the economic value of those relationships did not belong to him because he had conveyed control of the goodwill to the corporation through the employment contract and non-competition agreement.  The dentist could not save the goodwill from taxation as a corporate asset by re-defining it as a personal asset in the purchase agreement or by arguing that the employment contract and non-compete agreement terminated upon the closing of the purchase.  

The court issued a cautionary note: “[S]o having then made himself available to the advantages of using the corporation, and having entered into the agreements that he did with the corporation, then why should we try then to allow him . . . out of what he got himself into.”  Thus, before entering into an employment contract or non-compete agreement with their own corporation, professionals should be mindful of the potential tax consequences.  Proper consultation with an employment law attorney and tax attorney can help professionals avoid entering into unintended binding agreements, and a hefty tax bill from the IRS.