When a C-corporation sells an asset and the corporation's owner goes to work for the buyer, there may be an incentive for the parties to pay the owner a higher salary than the market will bear, as disguised payments for the asset. That's because the purchaser can currently deduct salary, but must capitalize any purchase payments.
At the same time, there may be a trap: if the payments are found to be in substance purchase payments to the selling C-corporation, the payments will face double taxation, once at the corporate level and again upon distribution as dividends.
In H&M, Inc. v. Commissioner, T.C. Memo 2012-290 (October 15, 2012), H&M, Inc. agreed to sell its insurance business to a local bank and competitor. Under the purchase agreement, H&M agreed to sell "all files, customer lists, insurance agency or brokerage contracts, the name of [the insurance business], and all the goodwill of [the insurance business]" for $20,000.
The deal was contingent upon the agreement by H&M's owner - Mr. Schmeets - to work for the buyer for six-years and also enter into a covenant not-to-compete for a period of 15 years. Under these latter agreements, Schmeets would receive over $600,000 during the six years. The agreement was later modified, so that some of the compensation would be deferred, would earn interest, and would be payable to Schmeets' estate in the event that Schmeets died.
The Court found that there had been no appraisal of H&M's assets prior to entering into the agreement. In fact, the buyer didn't even examine H&M's financial records. In addition, prior to the sale, H&M had paid Schmeets a salary of about $29,000 per year.
The IRS argued that Schmeets' wages were actually disguised payments to H&M for the sale of the business and urged the Court to apply the "substance-over-form doctrine" to recharacterize the transaction.
While lamenting the parties' failure to adequately document the transaction, the Tax Court rejected the IRS' position. To demonstrate that the business was worth more than $20,000, the IRS would need to show that the assets were undervalued. But the only intangible that the IRS pointed to as being undervalued was the goodwill of the business.
Generally, there is no salable goodwill where the business depends upon the personal relationships of a key individual, unless there is an agreement that prevents that individual from taking his relationships, reputation and skills elsewhere.
Here, "there was convincing testimony that . . . . no one knew insurance better than Schmeets." Furthermore, Schmeets had no agreement with H&M (of which he was the sole owner, incidentally) that would have prevented him from going to work elsewhere. Thus, the business' goodwill had no value.
The Court also gave "no weight" to the opinion of the IRS' expert, who opined that Schmeets' new salary was excessive, since the expert ignored Schmeets' particular skills and level of experience.
Finally, the Court noted that, in negotiating the sale and related agreements, there was "virtually no discussion" about the tax consequences of the transaction.
The employment relationship was motivated by Schmeets' desire for guaranteed employment and the buyer's desire to harness his skills, not for "massaging the paperwork for its tax consequences."