Valuation Corner: Personal or Corporate? Bross Trucking Case Illuminates the Nature of Goodwill

11/17/2015 - By Zachary Farrington

The concept of personal goodwill is alive and well — and it has been reinforced by a recent court case, Bross Trucking, Inc. v. Commissioner of Internal Revenue.

To briefly review, personal goodwill is goodwill that an employee or share-holder of a corporation owns separately from the goodwill of the company. For example, a business owner may have personal goodwill related to his or her reputation, specific skills, knowledge, personal relationships, judgment, expertise, personality or management style.

These are all qualities that customers value deeply — and often consider the center of their commercial relationship with the corporation. These intangible characteristics translate into an intangible asset that is generally considered to be inseparable from the individual.

In a valuation related to a transaction, there’s an important reason to assess the value of personal goodwill: avoiding double taxation. When a C corporation is sold, the gains are taxed at the corporate level — up to a 35 percent effective tax rate — and then again at the shareholder level.

However, if personal goodwill can be properly allocated from the sale price and attributed to the owner, gains from the sale of personal goodwill are only taxed at the shareholder’s capital gains tax rate. Thus, the IRS’s concern for the proper existence and treatment of personal goodwill.

Damaged Reputation Lead to Shut Down
In the case of Bross Trucking, determining which entity — the company or the shareholder — owned the goodwill became a $2.7 million question.

Chester Bross founded Bross Trucking in 1982 and owned 100 percent of the company. In the late 1990s, the company was cited by the Department of Transportation (DOT) for some safety problems, and regulatory scrutiny of the company’s operations increased in the form of audits and investigations.

Eventually Mr. Bross decided to close Bross Trucking because its reputation was severely damaged. He feared that the government would possibly shut down the business and believed that continuing to operate might impact the success of other companies he owned. However, in 2003 Bross’ three sons founded a new company, LWK Trucking, and employed about half of Bross Trucking’s former employees.

In 2011, the IRS demanded $2.7 million in corporate income tax and gift tax from Mr. Bross and his wife. According to the agency, an appreciated intangible asset in the form of goodwill was transferred from Bross Trucking to Chester Bross, who then made a gift of the goodwill to his sons. The IRS contended that the company should have recognized a gain as if the goodwill were sold to Mr. Bross at fair market value, and Mr. and Mrs. Bross should have paid tax on their “gift” to their sons. Team Bross strongly disagreed.

Who Owns the Goodwill?
The Bross Trucking case hinged on the question of who owned the goodwill — the company or Mr. Bross? That’s because in 1998, a pivotal goodwill case, Martin Ice Cream v. Commissioner, established that “a business can only distribute corporate assets and cannot distribute assets that it does not own.”

The Martin Ice Cream case also established that without an employment contract or a non-compete agreement, the company couldn’t own an intangible asset — like personal goodwill — that belonged to an employee or shareholder.

In the Bross case, the IRS contended that the goodwill owned by Bross Trucking and distributed to Mr. Bross and then given to LWK included an established revenue stream, a developed customer base, transparency of the continuing operations between the entities, an established workforce, and continuing supplier relationships.

The tax court disagreed, ruling that the goodwill was primarily owned by Mr. Bross and that the company therefore couldn’t transfer it. As the court considered the elements of goodwill in question, it noted that:

• Mr. Bross didn’t have an employment contract or a non-compete agreement with Bross Trucking. Without this type of agreement, the company had no right to Mr. Bross’s future services or his personal goodwill.

• The Bross sons never worked at Bross Trucking and Mr. Bross never worked at LWK Trucking. The court believed that customers of Bross Trucking chose to work with the com-pany because of their relationship with Mr. Bross. The sons didn’t contribute to the goodwill of Bross Trucking.

• No tangible assets were transferred from Bross Trucking to LWK Trucking. In fact, although Bross Trucking ceased operations, it retained all of the licenses and insurance required to continue in business.

The court said the only element of goodwill that possibly was transferred was a “workforce in place.” But since only 50 percent of the Bross Trucking workforce moved to LWK Trucking, the court found that half a workforce didn’t meet the definition of a workforce in place.

The court also noted that while Bross Trucking did have some corporate goodwill in the form of its name and reputation, the company’s regulatory problems actually created a negative association with the company and that “continuing supplier relationships” were not a given. In other words, the Bross name was actually a liability, not an asset.

In fact, the court found that customers wanted to move their business from Bross Trucking because they were afraid the company was going to be suspended by the DOT due to regulatory problems. The court ruled that the company didn’t own the goodwill and that Mr. Bross did. Therefore, there was no transfer of intangible assets and no taxable event.

The Taxpayer Wins
Some consider Bross Trucking v. Commissioner to be a case of IRS overreaching. But others were delighted to have another “good case” regarding personal goodwill, with clear facts and circumstances for the court to discuss and discern. The good news for taxpayers is that the case clearly underscores the outcome of the Martin Ice Cream v. Commissioner case and establishes more precedent for taxpayers and their attorneys in cases where personal goodwill is involved.

Of course, every case is different and goodwill is a complicated concept. For this reason, it’s important to work with an experienced valuation analyst in cases where goodwill is a factor.

We are always willing to help you answer questions about goodwill and valuation. Please call us to assist you.