Sale of Business Generates Ordinary Income

Article excerpt

The Tax Court held that payments to a taxpayer from the sale of his consulting business that he reported as long-term capital gain from his goodwill should instead be taxed as ordinary income. It held that the sales agreement that allocated amounts to the taxpayer as goodwill and to his wholly owned corporation for future consulting services and its client list were not based on economic realities but rather were determined to minimize taxes.

When a taxpayer sells a business in which his or her personal relationships with clients/customers are important to the purchasing entity and, after the sale, is employed by that entity;, a question arises whether payments received by the taxpayer are for the taxpayer's future services or for the taxpayer's goodwill. Amounts received for goodwill result in capital gain, while payments for services result in ordinary income. The existence of goodwill is a question of fact determined on a case-by-case basis. See Butler v. Commissioner, 46 TC 280.

James P. Kennedy was the sole shareholder of his employee benefits consulting business, KCG International Inc., in addition to being one of its two full-time employees. During 2000, Mack & Parker Inc. (M&P) offered to purchase the consulting business and have Kennedy join M&P as a consultant. M&P offered Kennedy a percentage of the annual income generated from KCG clients over the next five years. Later in 2000, the parties executed a final purchase-and-sale agreement that consisted of a goodwill agreement, consulting agreement and an asset purchase agreement.

Under the agreements, Kennedy would work without salary for M&P to continue providing services to his former clients for the next five years, after which he planned to retire. Also, under the agreements, Kennedy and KCG would not compete with M&P for five years. M&P would make a lump-sum payment of $10,000 to KCG and annual payments to KCG and Kennedy for five years. The annual payment amounts would depend on revenue received from Kennedy's former clients and were allocated 75% to Kennedy in exchange for the "personal goodwill" associated with his customer relationships, his know-how and his promise not to compete or otherwise engage independently in employee benefits consulting. The other 25% was allocated to KCG for its client list and noncompete agreement. …