Goodwill valued and taxed
By Mark E. Battersby

Goodwill is one of those intangible business assets that usually has little or no impact on your practice’s tax bill — until least expected.

If you determine who “owns” that goodwill now, you can often avoid expensive surprises and reap substantial tax savings somewhere down the road.

That is because if goodwill can be allocated to the practice’s principal, rather than the practice entity, tax savings may result.

WHAT IS IT?

Goodwill is an accounting term for the value of an all-too-real, but intangible, business asset, such as the value of a brand name your practice has built up over time. Goodwill is the likelihood patients and referring sources will continue to support the practice regardless of a change in ownership or provider. It is the value of the practice as a going concern, the office location, telephone number, a trained and assembled workforce (staff), and the custodial rights to the patients’ medical records.

Unfortunately, the goodwill of a chiropractic practice is among the most difficult assets for which to place a value. After all, rarely does goodwill have an original purchase price and it cannot be seen. Yet, goodwill is one of the most valuable assets in your practice.

Goodwill related to the practice entity is referred to as “enterprise goodwill,” or “going-concern” value. Marketable or vendible goodwill can be valued and sold. But no value can be assigned to goodwill that is purely personal or professional — that is, related solely to the individual who owns the practice.

TAX IMPLICATIONS

When an incorporated chiropractic practice sells its assets and distributes the proceeds to its shareholders, the overall tax liability can often be reduced if some portion of the proceeds is allocated to shareholders, rather than to the corporation.

It is impossible to simply assign the proceeds received in exchange for tangible and intangible assets titled in the corporate name to either the practice or the principal. Some flexibility may exist, however, to characterize consideration paid for intangibles (such as goodwill, going-concern value, and a covenant not to compete as payments to the shareholder).

A common tax dilemma arises whenever a chiropractor attempts to sell his or her practice only to discover the net after-tax proceeds will be substantially reduced by the dreaded double tax (taxed once at the corporate tax rate and again when those nondeductible distributions are added to the shareholder’s tax return).

One well-known tax strategy involves allocating goodwill to the practice’s principal, rather than to the practice entity.

Many businesses manage the double-taxation dilemma by paying deductible bonuses, royalties, and similar payouts to the principals to keep corporate profits — and tax bills — low.

The problem often reappears when the chiropractor sells the practice. Most buyers will not purchase the stock for liability and/or tax reasons resulting in an asset sale. This sale will be subject to the double tax and the usual methods of minimizing the double tax will be insufficient to eliminate the double tax in the year of the sale.

The limited options available to the seller involve giving the seller employment, consulting, or noncompete payments. These payments, however, are subject to ordinary income tax rates and possibly employment taxes as well. These payments must also have economic substance with respect to actual employment or consulting services performed in order to withstand the scrutiny of the IRS.

A better and more effective solution to the double-taxation problem may be to allocate a portion of the purchase price to the personal goodwill of the shareholders. Tax courts have ruled that goodwill can be attributed to the corporation as well as to the principal. Based on this bifurcation of goodwill, the owner’s personal goodwill is a separately saleable asset that avoids the double tax and is subject to favorable capital gains rates.

DO YOU HAVE GOODWILL?

The determination of whether goodwill exists in your chiropractic practice, and, if so, whether it belongs to the practice entity or to you, is relevant whenever tax or economic benefits may be realized by minimizing the practice entity’s valuation. This happens in corporate asset sales, divorce, bankruptcy, sales and liquidations, and gifts and estates.

According to tax rules, capitalized cost of goodwill and most other intangible assets acquired after Aug. 10, 1993, and used in a trade or business or for the production of income, are ratably amortized or written off over a 15-year period generally beginning in the month of acquisition.

Intangibles amortized under this provision are referred to as “Section 197 intangibles.”

Generally, self-created intangibles are not amortized under Code Section 197 unless created in connection with the acquisition of a trade or business. Exceptions are provided for government-granted licenses, permits and rights, covenants not to compete entered into in connection with the purchase of a business, and franchises, trademarks, and trade names. However, certain self-created intangibles without an ascertainable useful life may be amortized over 15 years.

What are your practice’s intangible assets and what is their value? The asset is generally viewed as some combination of the reputation, personal relationships with customers and suppliers, and the expertise of the shareholder.

Someone facing bankruptcy or divorce will argue that any goodwill in his or her practice is personal and the marital estate or bankruptcy estate should not include a value for goodwill that may be distributed to a creditor or ex-spouse.

But that same individual may take the opposite position that all of his or her goodwill is related to the practice entity in order to acquire favorable capital gains treatment.

Tax savings can be achieved by shifting value allocations from business or practice goodwill to personal goodwill. Knowledgeable, independent business appraisers understand the impact of these factors and can assist you in determining the proper allocation.

However, the time to think about the value of your practice’s goodwill and ownership of that goodwill is now, not later.

Mark E. Battersby is a tax and financial advisor, freelance writer, lecturer, and author with offices in suburban Philadelphia. He can be contacted at 610-789-2480.

DISCLAIMER: The author is not engaged in rendering tax, legal, or accounting advice. Please consult your professional advisor about issues related to your practice.