The Ability to Separate Personal Goodwill from the Overall Goodwill of the Company May Have Significant Financial Benefits to the Owner
The concept of personal goodwill versus enterprise goodwill is important to business owners in two contexts:
- Income tax at time of sale
- Divorce
In the Case Of a Sale of a C Corporation, for Example:
Proceeds received from the sale that can be allocated to the personal goodwill of the seller may be taxed at much more favorable rates. In the case of divorce, depending on the state, personal goodwill may not be considered a marital asset. Learn more here.
How Goodwill Is Defined
The International Glossary of Business Valuation Terms defines goodwill as “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.” This goodwill can attach to the enterprise or to the working owner depending on the facts and circumstances regarding the relationships with the customers and other outside stakeholders.
The concept of personal goodwill has been well documented and discussed in professional business appraisal texts and periodicals. The concept has also been reviewed and accepted in both tax and family courts. The methodologies applied have developed and been “cross-pollinated” in both contexts.
The leading published educators in business valuation define personal goodwill as follows:
Gary R. Trugman, CPA/ABV, MCBA, ASA, MVS.
“Logic states that if something cannot be sold, it cannot have value. However, a license provides the professional with the ability to make a living, and therefore, it has intrinsic value to the individual licensee. … Professional practices generally provide specialized services, which require the owners, and frequently their employees, to possess special levels of knowledge. Because of this, the value of the practice is highly dependent on the skills, reputation, and efforts of individual professionals. Therefore, some of the value of the practice is attributable to the personal reputation or skill of the owner and may not be transferable to a buyer. For example, a skilled heart surgeon cannot transfer his or her skilled hands to a willing buyer. This is known as professional goodwill. … The existence of professional goodwill is based on the fact that clients come to the individual, as opposed to the firm. This may be based on the individual’s skills, knowledge, reputation, personality, and other factors. The implied assumption is that if this individual moved to another firm, the clients would go with him or her.”
[Trugman, Gary, Understanding Business Valuation, 5th ed., New York: AICPA, 2017]
Dr. Shannon P. Pratt, DBA, CFA, FASA, MCBA
“In general, goodwill is defined as the ability to earn a rate of return in excess of a normal rate of return on the net assets of the business. In marital dissolution cases, this goodwill may require allocation between two types of good will: (1) institutional (or practice) goodwill and (2) professional (or personal) goodwill. Professional or personal goodwill may be described as the intangible value attributable solely to the efforts of or reputation of an owner spouse of the subject business. Institutional [enterprise] or practice goodwill may be described as the intangible value that would continue to inure to the small business of professional practice without the presence of that specific owner spouse.”
[Pratt, Shannon, Robert F. Reilly and Robert P. Schweihs, Valuing Small Businesses and Professional Practices, 3rd ed., New York: McGraw-Hill, 1998]
Separating Enterprise and Personal Goodwill
Various methods for separating enterprise and personal goodwill have been discussed in the leading business valuation texts and periodicals.
David N. Wood published An Allocation Model for Distinguishing Enterprise Goodwill from Personal Goodwill in the Fall 2004 edition of the American Journal of Family Law. He also published a follow-up article, Goodwill Attributes: Assessing Utility in the January/February 2007 edition of The Value Examiner. Both articles discuss application of multivariate utility theory in allocating goodwill to the enterprise and the professional and have been peer reviewed, tested in family and tax courts for many years and remain accepted practices.
The multivariate utility theory includes a process of assigning goodwill to various attributes or factors of the Business that create goodwill, attributing and weighting those attributes to the enterprise or the professional based on the appraiser’s informed judgment, and calculating an indication of the allocation of goodwill between the enterprise and the professional.
Business Factors that Create Goodwill
While no single method has been selected as the best, the factors that should be considered include:
- Age and health of the owner
- Demonstrated earning power
- Reputation in the community for judgment, skill, and knowledge
- Comparative success
- Nature and duration of the business
- Marketability of the business
- Types of clients and services
- Location and demographics
- How the fees are billed
- Source of new customers
- Individual practitioner’s amount of production
- Workforce and length of service
- Competitors in the community competing in the same service or specialty
A Practical Approach to Allocating Goodwill
Each of these factors is analyzed in the context of belonging to the person or the enterprise, and the results used to allocate total goodwill between the two. While the method is somewhat subjective, it does present a practical approach to allocating goodwill that has been peer reviewed.
Accuracy is insured through the business appraiser’s informed judgment in determining the nature of the value associated with each factor.
