Richard GoldsteinRichard Goldstein

It seems to me that the PR merger/acquisition market is hot again. Many larger agencies are acquiring smaller ones. If you think about it, the most significant asset that a PR agency has to sell is goodwill. There is not a heavy investment in tangible property for most agencies.

Business goodwill is an intangible asset that represents the portion of a business value that cannot be attributable to other assets. For the vast majority of service businesses, it’s their most significant asset that will be transferred to the buyer.

The factors that contribute to the creation of business goodwill includes: going concern value, excess business income and the expectation of future economic benefits.

For example, David Jones PR Inc. is a $4 million revenue PR agency doing business as a corporation. The profitability of the agency is approximately $1.3 million and it’s valued at approximately $7.0 million (somewhat less than five times earnings). The net asset of the agency, assets minus liabilities, is about $1.5 million. Most of the assets consist of cash, accounts receivable and furniture and equipment. The liabilities are accounts payable and taxes payable. Whether or not you agree with the valuation is not relevant. What is relevant is that $5.5 million that’s being sold is nowhere to be found on the balance sheet. This excess is generally considered “goodwill.”

The sale of goodwill is considered the sale of an intangible asset of DJPR. If DJPR is a C corporation, the sale is taxable to the corporation. Because there is no distinction between corporate income tax rates of ordinary income or capital gain, the sale of the goodwill will be taxed at 35 percent. Unfortunately for David Jones, he will have to pay tax on the distribution of the sales proceeds he receives due to the sale.

In other words, there is “double” taxation on the sale. In order to reduce or eliminate this double taxation, David Jones may insist on the sale of his corporate stock to the buyer. The advantage of this is he will only have to pay tax once on the sale of stock.

The buyer, if you will, will step into his shoes and become the owner of DJPR. Generally, buyers try and avoid the purchase of stock for two reasons: the basis of the assets are less than the selling price (outside basis is higher than the inside basis of the assets), and the buyer will receive no tax benefit on the purchase (note: there are planning techniques that can possibly work around this by making elections under Section 338 of the Internal Revenue Code which is beyond the scope of this column).

Secondly, buyers are nervous about future liabilities that aren’t known at the date of acquisition. For example, assume DJPR was sold in 2013. In 2015, the IRS decided to audit the 2012 and 2013 tax returns of DJPR. The buyer, as the owner of DJPR, must handle the audit and pay any tax liability deemed owed. Of course, lawyers try to protect the buyer by placing a portion of the purchase price in escrow and other techniques.

If DJPR is an S corporation, life is easier. Generally, the sale of assets of an S corporation is taxed only once to the seller. The exception to this rule is the built-in gains tax in an S corporation liquidation. While this subject is beyond the scope of this column, suffice it to say, if DJPR was never a C corporation from its inception, no built-in gains tax will result.

Another problem area is the possibility that the S election is not recognized by a state and/or local jurisdiction. For example, New York City does not recognize S corporation status. Therefore, as far as New York City is concerned, DJPR is a C corporation. Therefore, the sale of DJPR will be taxable at the corporate level and again at the individual tax level to a resident of New York City.

Personal goodwill

In the sale of a PR agency, the goodwill of the agency, if attributable to the owner — in this case David Jones — may be treated as an asset sold by the owner. In this case, a double tax inflicted on the sale of the C Corporation will be eliminated or reduced. The personal goodwill is not considered a sale of a corporation asset and is not subject to double taxation or the built-in gains tax as mentioned above. The gain will be considered a capital gain subject to tax at the capital gains tax rate rather than the ordinary income tax rate. Keep in mind that a portion of the consideration may be in the form of a covenant not to compete or to contractually bind David Jones to perform consultation services to the purchaser of the agency. These types of arrangements will be subject at ordinary income not capital gains tax rates.

Net investment income tax

I’m sure that many readers of this column are familiar with the net investment income tax by now. The Internal Revenue Code in 2010 by way of Section 1411 added a tax on net investment forms of income. Therefore, interest, dividends and capital gains are generally subject to a 3.8 percent additional tax above a certain threshold. Net investment income includes net gains from the disposition of property except to the extent attributable to a trade or business that is not a passive activity. The activity of a C corporation is not a trade or business to David Jones, DJPR’ s owner. The gain on the sale of corporate stock, see above, is considered net investment income and therefore subject to the 3.8 percent tax. If personal goodwill is sold as part of the sale of DJPR, the gain should not be subject to the 3.8 percent tax. Evidence that personal goodwill exists is supported if the shareholders negotiate the sale of goodwill separately from the sale of corporate assets.

The issue of business versus personal goodwill should be reviewed by your tax advisor before, not after a contract is negotiated and signed.

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Richard Goldstein is a partner at Buchbinder Tunick & Company LLP, New York, Certified Public Accountants.