Personal Goodwill: How One Person Can Alter the Value of a Business

In some businesses, an employee’s or owner’s reputation, knowledge and/or relationships might be critical to the business’s current and future value.  When such “personal goodwill” exists, shareholders who are exploring selling their interest in the company may benefit from obtaining an independent valuation of this often overlooked intangible asset.

Goodwill is often separated into two different types: enterprise and personal goodwill. Most companies are aware of enterprise goodwill — especially those involved in mergers and acquisitions. Enterprise goodwill results from a combination of factors, such as the number of years the company has been in business, the expertise and strength of the staff, its general reputation, the number of and quality of locations and its overall profitability.

Personal goodwill, on the other hand, applies to individuals rather than a company. Factors related to personal goodwill include the individual’s years of experience; his or her professional licenses, unique skills or areas of expertise; peer and community reputation; and personal relationships with customers or clients. Personal goodwill is often recognized in professional, but can also exist in any commercial enterprise.

Some forms of personal goodwill are transferrable to the business — for example, contact lists or brand names. However, not all features of personal goodwill are transferrable; this non-transferrable goodwill is referred to as pure personal goodwill. An example of pure personal goodwill is skills such as those obtained by a neurosurgeon or dentist.

While personal goodwill is a concept that evolved in litigation matters, specifically in marriage dissolution cases, personal goodwill can play an important role in mergers and acquisitions. Prior to the commencement of a merger or acquisition, identifying and quantifying personal goodwill can have favorable tax implications for the seller by, among other benefits, having gains on personal goodwill assets being taxed at capital gains rate rather than ordinary income rates.

While the term “personal goodwill” does not appear in the Internal Revenue Code, it is a creation of case law and was established by U.S. Tax Court case, Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998). In that decision, the tax court reaffirmed that when a corporation has no employment contract with an employee (in this case, the owner) the employee’s personal relationships are not corporate assets. Martin Ice Cream recognized that personal goodwill may be unique and is present only if supported by particular facts.

Because of Martin Ice Cream, over the past 20 years, the courts and valuation experts tested various methods to establish and quantify pure personal goodwill including:

With vs. Without Method— This approach determines the business enterprise value of the company overall — with and without the key individual anticipated to have personal goodwill. The question this methodology answers is how much income would be lost without the efforts of the key individual and his or her personal goodwill. For example, an individual starts a company selling widgets. Over the years, he developed a great personal relationship with each of his customers. If he were to compete against the original company he founded, many of his customers would probably stay with him even though he was with a different company.

Bottom–Up Method — This method applies similar concepts as are used in a purchase price allocations. The appraiser allocates the value of the enterprise to the tangible and identified intangible assets. Any remaining value is attributable to personal goodwill.

Top–Down Method — This method values the business enterprise, but then attempts to separate total goodwill into personal goodwill and enterprise goodwill. The Multi–attribute Utility Model (a point–scoring method) can help separate the two types of goodwill. For example, an individual starts a company featuring his name, selling replacement widgets. He thought of a new, never–before–developed concept, created the infrastructure necessary, has an in–depth knowledge of the industry he serves, has personally developed relationships with key suppliers, and been a strong community philanthropist. Everyone knows who he is and what his business does. A good portion of the business enterprise value is attributable to his knowledge, relationships and name.

If structured properly, the seller of personal goodwill can receive significant benefits with no adverse tax impact to the buyer. However, allocations of personal goodwill must be supported and be objective. When determining whether a personal goodwill valuation is appropriate, one must consider myriad factors. Any individual anticipating he or she may have personal goodwill in a company should consult a tax professional in addition to a qualified business enterprise appraiser with experience in valuing personal goodwill.