How a practice's 'good will' is valued and taxed

Good will is one of those intangible business assets that usually has little or no impact on a veterinary practice's tax bill — until least expected.

Does personal good will exist?

Determining in advance who "owns" that good will often helps avoid expensive surprises and can bring substantial tax savings somewhere down the road.

However, if it's ignored, that same good will also can work against a veterinarian in a practice sale, in a divorce or during the transfer to the veterinarian's heirs.

The savings usually result when good will can be allocated to the practice's principal, rather than to the practice entity.

Good will as an asset

Good will is an accounting term for the value of an all-too-real but intangible business asset, such as the value of a brand name that is built up by a veterinary practice over time.

Individuals who create good will through their skill at running a veterinary practice cannot, of course, claim a tax deduction for it. When good will is sold to someone else, however, the buyer gets to deduct it because its value is assumed to erode.

Good will is the likelihood that patients and referring sources will continue to support the practice regardless of a change in ownership. It is the value of the practice as a going concern, the office location, telephone number, a trained work force and the custodial rights to patients' medical records. Enterprise goodwill value is protected by the seller's promise not to compete after the sale, among other things.

The good will of a veterinary practice is among the most difficult assets on which to place a value.

The form of good will that is related to the practice entity is referred to as "enterprise good will," or "going-concern" value.

Good will that is marketable or vendible can be valued and sold. Conversely, no value is assigned to good will that is purely personal or professional.

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

Obviously, it is impossible simply to assign the proceeds received for tangible and intangible assets titled in the corporate name to either the practice or to the principal.

Some flexibility may exist, however, to characterize what is paid for intangibles (such as good will, going-concern value and a covenant not to compete) as payments to shareholders.

Separations and transfers

A common tax dilemma arises when a veterinarian tries to sell his or her practice, only to discover that the after-tax proceeds will be reduced substantially by the dreaded double tax (once at the corporate tax rate and again when those non-deductible distributions are added to the shareholder's tax return).

One well-known strategy for dealing with that involves allocating good will to the veterinary-practice's principal.

Many practices pay deductible bonuses, royalties, etc., to the principals to keep corporate profits — and tax bills — low. The problem often reappears when the veterinarian sells the practice.

Most buyers will not (or, in the case of many professional practices, cannot) purchase the stock for liability and/or tax reasons, resulting in an asset sale.

This sale will be subject to the double tax; the usual methods of minimizing the double tax will be insufficient to eliminate it in the year of the sale.

The limited options available to the seller include having proceeds paid directly to the seller as employment, consulting or non-compete payments. These payments, however, are subject to ordinary income-tax rates and possibly employment taxes.

These payments also must have "economic substance" with respect to actual employment or consulting services, to withstand IRS scrutiny. The most effective solution may be to allocate a portion of the purchase price to the personal good will of the shareholders.

Legitimately divorcing good will

In a 1998 court case, a creative taxpayer successfully argued that the good will of a business can be divided into good will owned by the corporation and good will owned by the owner. The taxpayer convinced the tax court that the corporation's success was largely based on the personal reputation and industry contacts of one of the owners and that most of the good will was personal to the owner and had not been transferred to the corporation.

Based on this bifurcation of good will, the owner's personal good will is a separate, saleable asset that avoids the double tax and is subject to favorable capital-gains rates.

Good will existing

The determination of whether good will exists in your veterinary practice and, if so, whether it belongs to the practice entity or to the individual, is relevant whenever tax or economic benefits may be realized by minimizing the practice entity's valuation. There may be many such situations, including:

• Corporate asset sales

• Divorce

• Bankruptcy

• Sales and liquidations

• Gifts and estates

Tax rules for 'acquired' good will

The capitalized cost of good will and most other intangible assets acquired after Aug. 10, 1993, and used in a trade or business, or for the production of income, are amortized 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 include government-granted licenses, permits and rights, non-compete covenants and franchises, trademarks and trade names. However, certain self-created intangibles without an ascertainable useful life may be amortized over 15 years.

Divisive good will

Regardless of the reason a determination of goodwill value is desirable, the primary issue is deciding just what are the intangible assets of a veterinary practice and what is their value? The asset usually is viewed as some combination of the reputation, personal relationships with customers and suppliers and the expertise of the shareholder.

The best case is one where customers and suppliers perceive themselves as dealing with the individual shareholder, rather than with the legal entity. A professional practice is most likely to support this position.

There are times when a veterinary-practice principal may take the position that any good will is personal and has no value; at other times, he or she may argue the opposite.

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

In another situation, perhaps when seeking favorable capital-gains treatment, the same professional may take the opposite position that all of his or her good will is related to the practice entity.

Usually, tax savings can be achieved by shifting value allocations from business or practice good will to personal good will. Knowledgeable, independent business appraisers understand the impact of these factors and can assist any veterinarian in determining the proper allocation.

However, the time to think about both the value of the veterinary operation's good will — and who owns it — is now, not later.

The value of good will and other intangible assets can be legitimately determined in the case of a sale because the value associated with the asset often is negotiated between buyer and seller, the same way they agree upon the purchase price of other tangible and intangible assets. However, since not all transfers of good will involve sales, it sometimes is useful to have a third-party appraisal.

Mark E. Battersby is a financial consultant in Ardmore, Pa.