In Part I, we discussed that personal goodwill is commonly valued separately in divorce cases when state statute treats personal goodwill as a non-marital asset. Personal goodwill is also valued separately for tax purposes in an asset sale of a C Corporation. There are two steps required to value personal goodwill. The first step, as discussed in Part I, is to determine the existence of personal goodwill by identifying attributes of personal goodwill not owned by the corporation and not assigned or transferred to the corporation.
In this segment, I will discuss step two: the valuation of the attributes associated with personal goodwill held by the key person. There are three methodologies used to value personal goodwill: residual method, multi-attribute utility model, and discounted cash flow method.
THE RESIDUAL METHOD
The residual method is applicable in a tax engagement for purchase price allocation of the transaction. The value of the enterprise is determined independently of the negotiated price. The enterprise value is subtracted from the negotiated price to arrive at the personal goodwill (residual). I used the residual methodology in a tax valuation engagement of an asset sale of a natural gas distributor. The seller engaged a tax attorney in the eleventh hour that obtained signatures of the parties acknowledging neither had obtained valuations and both agreed a valuation could be obtained after the closing to determine the allocation of personal goodwill, if any.
Total asset purchase price was $52.0M with $19.25M tangible assets, $7.50M real estate, non-compete agreements and consulting agreement of $6.05M and $19.2M assigned to intangible assets. The fair market value of the enterprise, non-compete and consulting agreements are $36.85M. The residual of $15.15M was allocated to personal goodwill.
THE MULTI-ATTRIBUTE METHOD
The multi-attribute utility model identifies the attributes of all intangible assets, assigns the attributes held by the key person or the Company, and weights the attributes held by the key person and the Company. The facts in the subject case above supported the allocation of value to personal goodwill. The report included in-depth analysis of the key person attributes and the market.
THE DISCOUNTED CASH FLOW METHOD
The discounted cash flow method is used to forecast the future cash flows of the entity without the attributes associated with the personal goodwill. The net present value of the future cash flows represents the value of the enterprise without the key person attributes.
Another tax valuation engagement involved an Ophthalmology practice merger. The negotiated price of the assets was $2M. The conclusion of value of personal goodwill was $1.143M with $0.469M allocated to enterprise goodwill and $0.388M allocated to tangible assets. The valuation analysis focused on the identification of the attributes associated with the intangible assets. Both of these engagements supported the conclusion of value with in-depth analysis of industry market conditions and the performance of the key producers.
In both of these engagements a legal opinion letter was obtained from the tax attorney. The facts relied upon in the valuation engagements were reinforced by the legal opinion and prevailing case law. Both of these engagements were subjected to examination by the IRS resulting favorably for the taxpayer.
The facts of each engagement will vary with some transactions justifying obtaining personal goodwill valuations and legal opinion letters. Careful evaluation of the facts is necessary before proposing valuation services. The tax savings could be significant and merit the cost of supporting the allocation of the purchase price to personal goodwill.
I would welcome the opportunity to discuss with you the attributes associated with your client’s asset sale.