tax considerations       

Martin Ice Cream and Norwalk

Closely held businesses often attribute much of their success to the personal attributes of their owners. While contributions of capital, land and other tangible items generally are necessary to get any business off the ground, the more significant factor regarding the long-term survival of small, closely held entities is frequently those personal intangibles created and held by the owners themselves, such as relationships with customers or clients or recognition as one in the industry possessing unique skills.

It is possible that over time one could come to view these personal intangibles as assets of the company itself, in the form of items such as corporate goodwill, even though the business owners were themselves responsible for the creation of the assets and in fact may have not relinquished their own personal rights in such assets. Whether these personal intangibles are owned by the company or its individual owners can be particularly significant from a tax perspective upon a sale or liquidation of the business, especially when the selling or liquidating company is a C corporation. At stake in such a case is the choice between one or two levels of taxation. For example, in the case of a sale of the assets of the business, if the so-called personal intangibles are deemed to be owned by the company, the gain attributable to the sale of the personal intangibles will be subject to two levels of taxation (once at the corporate level upon the sale of the assets and again at the time the proceeds from the sale of the assets are distributed to the shareholders). By contrast, if the personal intangibles are deemed to be owned by the individual shareholders, then a sale of this asset will only be subject to one level of tax at the shareholder level and normally will be subject to tax at capital gains rates.

Two recent United States Tax Court decisions provide support for the proposition that in certain cases personal intangibles may be treated as assets held by individual owners (as opposed to the corporation) and illustrate that tax savings may be realized in certain situations through careful planning.

In Martin Ice Cream Co. v. Commissioner, 110 T.C. 18 (1998), Arnold Strassberg and his son, Martin, together owned all of the stock of Martin Ice Cream Co., a corporation engaged in the business of ice cream distribution. Prior to the formation of Martin Ice Cream Co., Arnold had worked for more than a decade in his own wholesale ice cream distribution business. The success of Arnoldís ice cream marketing programs enabled him to develop strong business relationships with the managers and owners of a number of supermarket chains. After having worked with his son in Martin Ice Cream Co. for a brief period, Arnold was approached by the founder of Haagen-Dazs Co., Inc., which had unsuccessfully attempted to introduce its products to supermarket chains. Arnold accepted the opportunity and shortly thereafter Martin Ice Cream Co. became the first distributor of the Haagen-Dazs brand to supermarkets, quickly establishing distribution relationships with four major supermarket chains.

Several years later, representatives of Haagen-Dazs began speaking with Arnold about acquiring his relationships with the supermarkets, removing Martinís Ice Cream Co. as the middleman in the distribution, and thereby obtaining direct access to the supermarket chains. Haagen-Dazs had determined that Arnoldís relationships had value, which it was willing to pay for. The company had no interest, however, in continuing to work with Martin Ice Cream Co. or in acquiring any of its physical assets. Through a long series of negotiations with Haagen-Dazs, Arnold decided to sell and determined that the best manner of structuring the transaction would be to create a subsidiary, named Strassberg Ice Cream Distributors, Inc., to which all of the supermarket relationships of Martin Ice Cream Co. were transferred and held as the corporationís only assets. Immediately thereafter, all of the subsidiaryís stock was distributed to Arnold in exchange for his interest in Martin Ice Cream Co. Strassberg Ice Cream Distributors, Inc. then sold the assets to Haagen-Dazs for $1,500,000.

Upon a subsequent review of the entire transaction, the Tax Court concluded that the assets sold to Haagen-Dazs were never owned by Martin Ice Cream Co., and therefore, the company could not have transferred them to its subsidiary for purposes of the sale. Instead, the court determined that Arnold was always in possession of these assets. He had developed his relationships with supermarket owners prior to conducting any business with his son and had never taken any action which would have resulted in the transfer of the assets to Martin Ice Cream Co., because he had never contributed them to the corporation or entered into any employment, noncompete or other type of contractual arrangement. At most, according to the court, Martin Ice Cream Co. had the benefit of the use of Arnoldís personal goodwill while he was associated with the company, and this goodwill was completely separate and distinct from any intangible corporate goodwill. Accordingly, Arnold himself was deemed the seller of the intangible assets.

Similarly, in Norwalk v. Commissioner, 76 T.C.M. (CCH) 208 (1998), the Tax Court concluded that the goodwill associated with a business was actually that of its owners, rather than of the corporate entity itself. In that case, two certified public accountants began practicing together in a single firm organized as a professional corporation. At the time of the corporationís formation in 1985, each accountant signed an employment agreement, which contained certain covenants restricting each accountantís ability to compete with the corporation or otherwise use the corporationís client list or other client information in his own behalf. These employment agreements were initially executed with only five-year terms, however. Then, in 1992, the two accountants determined to dissolve the corporation and distribute its assets in the complete liquidation of the entity, with no new employment agreements having ever been entered into with the corporation. Subsequently, the Internal Revenue Service asserted that at the time of the liquidating distributions, the corporation transferred to its two shareholders not only its tangible assets but also certain "customer-based intangibles," including the accounting firmís client base, client records and additional goodwill, which were argued to be assets of the corporation that would trigger taxable gain upon their disposition to the shareholders.

As in Martin Ice Cream Co., however, the Tax Court refused to accept the position of the Internal Revenue Service with respect to these intangible assets, finding instead that the corporation possessed no goodwill of its own, which could be distributed to its shareholders at the time of its liquidation, as there was no longer any contract that could be enforced against the shareholders that would restrict their individual practices. In the absence of a noncompete or similar agreement, the accountants had not transferred their rights to their experience, acquaintances, skill or other personal intangibles and were free to work with the parties on the corporationís client list in any manner they wished to. As a result, these intangibles had no value to the corporation itself.

As these two cases illustrate, it may be possible in certain instances for owners of a corporation to avoid the harsh effects of double taxation with respect to a significant portion of the value of their business assets if those assets are properly characterized as personal goodwill of the individual shareholders. In such a case, the shareholder will receive upon a sale of the business that portion of the purchase price attributable to such intangibles reduced only by his or her own personal income tax liability, as the sale proceeds will flow to the shareholder without first passing through the corporation. To help ensure such treatment, however, a shareholder should avoid entering into a noncompete or employment agreement with the corporation and always act in a manner that reflects that such personal intangible assets are his or her own, instead of regarding them as having been either transferred to the corporation or created by the business entity.

In addition to the above-described tax benefits, other tax planning opportunities may also be available. For example, a shareholder seeking a means of removing cash from a corporation currently at capital gains rates could transfer his or her personal intangibles to the corporation for a fee; in such a case, a potential amortizable asset for the corporation would also arise. Furthermore, the ownership of personal intangibles at the individual shareholder level also might lessen the tax costs associated with the conversion of a corporation to a limited liability company.

As a result of these perhaps significant benefits, shareholders should always be mindful of these issues in connection with their tax planning whenever so-called personal intangibles are associated with a particular business enterprise.

This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.