Goodwill Requires Enforceable Covenant Not to Compete

Tax Court Judge Ruwe recently decided the case of Norwalk vs. Commissioner (TCM 1998-279), involving an assertion by the IRS of a gain on liquidation of an incorporated accounting practice. The case has substantial implications for the valuation of professional practices.

Mr. Norwalk and Mr. DeMarta formed DeMarta and Norwalk, CPAs, Inc. in 1985. They each entered into employment contracts with the corporation which specified that the employee had an "absolute right to unilaterally terminate this Agreement by providing ... written notice ... of ninety days." The Agreement also contained a Restrictive Covenant which forbade competing with the corporation during the term of employment, but not thereafter. Finally, a nondisclosure clause provided that the employee could not disclose the practice's clients during or after termination of employment.

In 1992, they determined that the practice should be terminated due to lack of profitability. The record indicated the earnings of the shareholder-CPAs were quite low and in fact they had to loan the practice money to keep it operating. Acting in their capacity as Directors of the Corporation, they voted to liquidate and distribute all of the assets to themselves. The assets included approximately $59,000 of fixed assets, which were contributed to another firm (Ireland) by DeMarta and Norwalk in exchange for partnership capital account balances of the same amount. Certain professional employees of the Corporation established their own practices subsequent to the liquidation, taking many of their clients with them. The Court noted that five years after the liquidation, only about 10% of the pre-liquidation clients were still serviced by the Ireland partnership. Ireland also leased the DeMarta and Norwalk office space for a period of approximately 21 months after the liquidation.

During an audit of the tax return for the year of liquidation, the IRS maintained that "customer-based intangibles" were distributed to the shareholders, in addition to the fixed assets. The purported constructive distribution resulted in a taxable gain to the corporation as well as a gain to the shareholders. The IRS measured the value of the intangibles at $635,000, consisting of $266,000 for the client list and $369,000 for goodwill.

The Court noted that goodwill had previously been recognized as a "vendible asset which can be sold with a professional practice" citing, e.g., Watson v. Commissioner (35 TC 203 (1960)). Goodwill in an accounting firm "may include an established firm name, a general or specific location of the firm, client files and workpapers ... a reputation for general or specialized services, an ongoing working relationship between the firm's personnel and clients, or accounting, auditing and tax systems used by the firm." The Court went on to say "Goodwill, then, is an intangible consisting of the excess earning power of a business. ... usually this extra value exists only because the business is a going concern. ... Goodwill may arise from: 1) the mere assembly of the various elements of a business, workers, customers, etc., 2) good reputation, customers' buying habits, 3) list of customers and their needs, 4) brand name, 5) secret processes, and 6) other intangibles affecting earnings." (Norwalk vs. Commissioner, ibid).

During the presentation of expert testimony, the Service's witness conceded that "Without an effective noncompetition agreement, the clients have no meaningful value." The Court also noted that many of the clients had followed the corporation's non-shareholder CPAs to their own practices subsequent to the practice's dissolution. "These characteristics did not belong to the corporation as intangible assets, since the accountants had no contractual obligation to continue their association with it." (emphasis added) The Court concluded that the corporation had no goodwill that could be distributed, citing MacDonald v. Commissioner, (3 TC 727) "We find no authority which holds that an individual's personal ability is part of the assets of a corporation by which he is employed where, as in the instant case, the corporation does not have a right by contract or otherwise to the future services of the individual."

It is well-established in both the business world as well as the Courts that the transfer of the "goodwill" of a professional practice generally requires an enforceable covenant not to compete in order to be fully effective. Goodwill is actually a misnomer, as the individual components of intangible value frequently present, and cited by the Court, are actually identifiable, and the term "goodwill" is best left to define that portion of excess earning power not attached to any other intangible. The portion of excess earning power which attaches to the individual is commonly referred to as personal or professional goodwill, and the remainder may be referred to as practice or business goodwill.

Although the Court provided an exhaustive listing of the potential components of intangible value, it focused its conclusion on that element of intangible value called personal goodwill. Although not stated explicitly by the Court, many of the other elements of intangible value were likely not present in this circumstance since the practice was dissolved. For example, the intangible asset workforce-in-place was not present since most of the firm's employees went on to competing practices. The practice ceased to function as a going concern after the liquidation, such that this asset, if present at all, was substantially diminished. DeMarta and Norwalk had to make personal loans to the practice to keep it operating such that it was unlikely that any excess earnings attributable to practice goodwill were present.

On the other hand, some elements of intangible value may have been overlooked. The firm which Mr. DeMarta and Mr. Norwalk joined did continue to use the practice's office space for a period of nearly two years, such that the intangible value associated with location might have been deemed to be transferred. The client files and workpapers, cited by the Court as an intangible, also seem to have been transferred, and some of these went with the shareholders and were used in their new firm.

(Portions of the following analysis are taken from The 1999 Medical Practice Valuation Guide Book, Including the Influence of Managed Care, by Mark O. Dietrich, CPA-ABV, (c) Windsor Professional Publishing, used with permission).

It would be unwise to view Norwalk and the cases cited therein as conclusive with respect to whether or not transferable goodwill exists in a professional practice. A memorandum decision of the Tax Court generally applies to those cases involving disputes as to facts, not as to the law, the latter cases being the subject of regular Tax Court decisions. It is possible that a different result might have been reached under slightly different circumstances, or if the IRS had done a better job presenting its view of the facts. The following discussion looks at other case law impacting practices operated as C corporations and the presence of goodwill.

There is a general rule of tax law that taxpayers are bound by the form of entity they choose to operate under. For example,

"Although a taxpayer has the right to arrange his affairs to reduce his tax liability, the substance of a transaction must govern its tax consequences regardless of the form in which the transaction is cast. Gregory v. Helvering, 293 U.S. 465, 469 (1935)." Wright v. Commissioner, T.C. Memo 1993-328

"In Burnet v. Commonwealth Imp. Co., 287 U.S. 415, this Court appraised the relation between a corporation and its sole stockholder and held taxable to the corporation a profit on a sale to its stockholder. This was because the taxpayer had adopted the corporate form for purposes of his own. THE CHOICE OF THE ADVANTAGES OF INCORPORATION TO DO BUSINESS, IT WAS HELD, REQUIRED THE ACCEPTANCE OF THE TAX DISADVANTAGES. [Emphasis added; fn. ref. omitted.]" Quoted in Jamar v. Commissioner, T.C. Memo 1991-602

"Having set up a separate entity through which to conduct their affairs, petitioners must live with the tax consequences of that choice. Indeed, the very exigency which led to the use of the corporation serves to emphasize its separate existence." See Moline Properties v. Commissioner, 319 U.S. at 440; David F. Bolger, 59 T.C. at 766.

For many years, the IRS took the position, enunciated in Revenue Rulings 57-480 and 60-301, that a sole practitioner in the professions could not 'sell' goodwill if it was "dependent solely upon the professional skill or other personal characteristics of the owner". They backed off somewhat from this position after a series of adverse court rulings, including the Watson case cited in Norwalk, modifying the position in Revenue Ruling 64-235, to "remove the implication that, as a matter of law, no salable goodwill exists in a professional firm which is solely dependent upon the professional skill or other personal characteristics of the owner."

The IRS modified its position on the matter yet again in Revenue Ruling 70-45.

The Internal Revenue Service has reconsidered Revenue Ruling 64-235, C.B. 1964-2, 18, which relates to whether payments received by a professional man upon the admission of partners to his practice represent consideration for the relinquishment of his right to a portion of the future earnings of the practice. That ruling is based upon the premise that although the facts of a particular case might support a transfer of goodwill by a professional man where he sold his entire practice, he could not, as a matter of law, make a partial transfer of goodwill when admitting partners to share in his practice.

Upon reconsideration, it is held that the question whether there has been a partial transfer of goodwill or merely an anticipatory assignment of future earnings of the practice will be treated as a question of fact.

As recently as 1996, in Private Letter Ruling 9621002, the IRS took a position fundamentally consistent with that of Revenue Rulings 64-235 and 70-45.

"Taxpayer also cites Malcolm J. Watson v. Comm'r, 35 T.C. 203, 213 (1960) for the proposition that compensation for the use of goodwill produces capital gain and that goodwill is viewed from the transferee's standpoint as "an opportunity to succeed to the advantageous position of his predecessors." While it is true that goodwill is a capital asset, ability, skill, experience, acquaintanceship, or other personal characteristics or qualifications do not constitute goodwill as an item of property, nor do they exist in such form that they could be the subject of a transfer." See Watson, at page 210 (quoting Providence Mill Supply Co., 2 B.T.A. 791 (1925)). (emphasis added)

"Moreover, Watson is factually distinguishable from this case. Watson involved the sale of a professional accounting practice by one accountant to two other accountants with whom he had formed a partnership. The terms of the contract expressly provided that Watson was selling, among other things, the goodwill of his accounting practice. The purchaser's thought they were buying goodwill. Furthermore, the Tax Court extended capital gain treatment to the taxpayer in Watson because he proved he possessed goodwill, separate and apart from his personal skills and abilities, which he could transfer." (emphasis added) Private Letter Ruling 9621002

This analysis indicates that the IRS may take seemingly inconsistent positions in the interest of raising money for the federal treasury. It is clear that that the transaction documents must clearly indicate that goodwill was separately bargained for in order for an individual to report payments for goodwill as capital gain items, rather than as ordinary income from a noncompetition agreement.

The Norwalk case has significant and perhaps far-reaching implications, especially in light of the spate of acquisitions of physician practices by exempt hospitals and other entities. The IRS is presently conducting audits of such transactions and many such audits will result in appellate and court proceedings as to the applicability of penalties under the Intermediate Sanctions provisions of the Taxpayer Bill of Rights.

At the core of the Court's argument is that an incorporated practice has no claim to the goodwill associated with an individual practitioner, or what is called personal/professional goodwill, in the absence of a specific contractual right: "We find no authority which holds that an individual's personal ability is part of the assets of a corporation by which he is employed where, as in the instant case, the corporation does not have a right by contract or otherwise to the future services of the individual." (Norwalk, citing MacDonald, ibid) This has substantial tax planning implications in the sale of any incorporated professional practice taxed as a C corporation. The portion of the sale proceeds allocable to personal or professional goodwill do not belong to the corporation unless the individual is contractually bound to the corporation. This, in turn, means that such proceeds can then be paid directly to the individual, and the characterization of those proceeds may be ordinary or capital, depending upon the facts and circumstances of a particular case.

The decision of the Court seems to partially void the notion that a taxpayer is bound by the advantages and disadvantages of the form of entity they choose. During the lifespan of the corporation in Norwalk, the benefit of the goodwill of the individual shareholders inured to the corporation. From some of the prior case law, one might conclude that incorporating a professional practice results in the transfer of the value of personal goodwill to the corporation. In Norwalk, one would conclude that no such transfer took place unless there was an affirmative statement of transfer via a noncompete or similar provision. This may constitute a major planning opportunity in the formation of a professional corporation. In the IRS' view, the salability of personal goodwill appears to be a function of the specifics of the transaction, including whether or not the buyer thought they were purchasing it and the seller(s) thought he(they) were selling it. (Private Letter Ruling 9621002)

Valuing a physician practice in connection with a sale to an exempt hospital, based upon the IRS Continuing Education Program Text on Valuation, requires use of a discounted cash flow method to determine Business Enterprise Value. Implicit in this method is the assumption that all of the intangible value reflected in the practice's earnings stream was transferable. The Norwalk case explicitly states that personal goodwill is not transferable in the absence of a covenant not to compete. Inclusion of such a covenant between the buyer and the selling corporation and physicians is presumably the norm, but in several states, e.g., Massachusetts and Alabama, the enforceability of such a covenant is either questionable or moot. In Florida, such a covenant is only enforceable if irreparable harm can be shown. Further, as noted above, the portion of the transaction consideration attributable to personal goodwill is not a corporate asset unless the corporation has a pre-existing contractual right to it.

At a minimum, many incorporated practices are likely to have reflected as income, sales proceeds properly attributed directly to their individual shareholders who had no pre-existing non-compete. Further, reporting such proceeds as corporate income and then paying the cash out as compensation to shareholders, may result in an unreasonable compensation attack by the IRS. If the proceeds were paid as a liquidating distribution, as argued by the IRS in the Norwalk case, corporate level tax will have been unnecessarily incurred.

The case also has important implications for valuators. It suggests that in valuing a professional practice operating as a C corporation, the employment contracts and other documents of the shareholders should be reviewed to ascertain if personal goodwill is an asset of the corporation due to the presence of a noncompete. If it is not, such goodwill should either be excluded from the valuation, or separately valued and specified as a non-corporate asset.

Norwalk also appears to place a premium on separately identifying the various components of intangible value, rather than lumping them together into a single category labeled 'goodwill.' In a court proceeding, a valuation which measures a single quantity 'goodwill' may have no probative value if it can be shown that only certain portions of the goodwill were relevant and no evidence as to the value of the individual components is presented. It seems likely that in Norwalk, the IRS would have had a greater chance of success if it had argued that the location, and particularly the client files and workpapers, had value independent of the shareholder-CPAs, or of two amorphous assets called "goodwill" and "client list."

A substantial portion of valuations are conducted with the tax authorities as a significant member of the likely audience. The health care industry has been the source of a large number of recent transactions which are now the subject of regulatory review. The Norwalk case offers a timely review of the factors influencing the value and transferability of professional goodwill, and potential defenses to IRS positions adverse to corporate treatment of intangible asset payments attributable to shareholders.

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