In a case closely watched by tax professionals, a district court has ruled that the amount received by a dentist shareholder on the sale of his professional service corporation was improperly allocated to personal goodwill. The court held that the personal goodwill was in fact a corporate asset. As a result, the corporation had to report as income the amount of the proceeds allocated to personal goodwill which subjected this income to corporate taxation at a flat 35 percent federal rate plus state taxation. Moreover, the dentist was required to report the proceeds received from the corporation individually as a dividend which under current law are taxed at a long term capital gain rate of 15 percent. This case adversely impacts dentists, other health care professionals and individuals who perform personal services that organize their practices as C Corporations.
The district court case referenced in this article stemmed from an audit of both the Larry E. Howard, D.D.S. Corporation and Dr. Larry E. Howard. During the 80's and throughout the 90's, Dr. Howard operated his dental practice through a C Corporation. C Corporations used for professional practices are categorized as personal service corporations and pay taxes at a flat 35 percent federal rate. They are not allowed to take advantage of the more liberal graduated rates which start at 15 percent for regular C Corporations. Furthermore, unlike S Corporations they file and pay tax at their own rates and as such are not flow through structures.
In 2002, Dr. Howard sold his practice to Dr. Brian Finn via an Asset Purchase Agreement. In that agreement, Dr. Howard was allocated approximately $549K for his personal goodwill and $16K for a covenant not to compete with Finn. Howard Corporation received just over $47K for its assets. Dr. Howard reported a $320,358 long term capital gain on his 2002 personal tax return from the sale of the personal goodwill. On audit, the IRS re characterized the sale of personal goodwill as a corporate asset and treated the amount received by the Howard's as a corporate dividend. As a result of this ruling, Dr. Howard's corporation had to recognize additional income of $549K, resulting in added corporate taxes of nearly $200K.
This case illustrates one of the major pitfalls associated with operating professional practices as C Corporations. Most planners advise their clients to organize their professional practices as S Corporations which are flow through structures. When an S Corporation sells its assets, the sale of goodwill is treated as a capital gain item which is passed down to the respective shareholders and taxed at the more favorable capital gain rates which are applicable to individuals. The S Corporation thus avoids the potential double taxation of proceeds in an asset sale. To circumvent this double taxation issue for personal service C Corporations, planners have split the purchase price in an asset sale between corporate assets and personal goodwill. The amount allocated to personal goodwill does not get reported on the corporate tax return but rather is taxed at the more favorable individual long term capital gain rate.
The planning technique for C Corporations that we have referenced in this article has been periodically attacked by the service in prior tax court cases. Most of which have been unsuccessful. In recent years, however, this technique has come under increased scrutiny. We expect this trend to continue with the emphasis on enforcement and the efforts to collect more tax from upper income Americans.
For the last several years, we have been converting existing personal service C Corporations over to S Corporations. Although there is a waiting period to take advantage of the more favorable attributes of the S Corporation when this conversion is made, the clock starts ticking. And once this waiting period expires, business owners can sell their practices with only one level of taxation which in most cases results in predominately long term capital gain. Professionals who have personal service C Corporations and especially those who are contemplating retiring or selling in the next decade must immediately evaluate the merits of a conversion to S status. Moreover, a thorough review of the employment contracts is also recommended with a focus on non-compete agreements which played a major role in this recent court decision.
The Optimal Financial Group is a team of professional from the legal, accounting and financial planning fields and provides comprehensive financial services to its clients. Optimal covers the tax stratosphere and places an emphasis on tax planning versus compliance activities. We work for our clients - looking for money among the thousands of dollars earned every year but paid out unnecessarily in taxes. For a complimentary consultation, please feel free to call 866-966-4923.
by Charles Dombek CPA, MBA
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