Avoid taxes in liquidation.

EXECUTIVE SUMMARY

* THE IRS SAYS DISTRIBUTIONS of customer-based intangibles to shareholders are taxable. When a firm or corporation distributes to its shareholders all of its assets, both tangible and intangible, and ceases doing business, the IRS says there is a taxable distribution of its intangible goodwill.

* THE CRITICAL ISSUE FOR TAX PLANNING is whether the assets distributed are considered property under IRC code section 336 and whether the corporation owns them.

* THE QUESTION OF WHO "OWNS" the clients and customer-based intangibles turns on whether there is an employment or noncompete agreement in effect at the time the intangibles are distributed. Without such an agreement, client goodwill attributable to the personal characteristics of a shareholder isn't a property right belonging to, or transferable by, a firm.

* A NONCOMPETE COVENANT, to be enforceable, must reasonably reflect an employer's protectable interest in both the nature and the scope of the restraint on the employee. Trade secrets, special processes, patents and proprietary information are among an employer's protectable interests, but how noncompete provisions create an employer property right isn't clear.

* THE PRACTITIONER SHOULD ADVISE the client to terminate employment and noncompete agreements with shareholders before liquidation.

* WHETHER PLANNING FOR A LIQUIDATION of their own professional practices or advising clients about the liquidation of a commercial organization, CPAs will find that the problems and the solutions associated with each are likely to be the same.

Proper planning requires CPAs to examine existing employment agreements with shareholder-employees.

Lawyers advise CPAs to have employment and noncompete agreements in their accounting practices. They recommend that all employees, including those who are shareholders, promise--in writing--not to take clients with them if they leave the firm. Such agreements can protect firms, the lawyers say. But what they might not say is that employment and noncompete agreements can create serious income tax consequences when a firm or corporation is liquidated and goodwill assets such as client relationships are distributed among the shareholders. There is the possibility of some relief, however: A CPA firm and its shareholders are in a better position to avoid serious tax consequences if such agreements are not in place when the professional corporation is dissolved.

The IRS asserts that distribution of "clients and customer-based intangibles" to shareholders is taxable, but the Tax Court has held that it isn't if a noncompete agreement between the shareholder or employee and the firm does not exist. This apparent contradiction presents some questions to which there are no black-and-white answers. In the cases discussed in this article, the Tax Court did not distinguish between personal service corporations, such as CPA firms, and commercial organizations, such as an ice cream distribution company, in identifying the individual ownership of customer-based intangibles. In planning for a liquidation of their professional practice or advising clients about the liquidation of a commercial organization, CPAs will find that the problems and the solutions are likely to be the same.

TANGIBLE OR INTANGIBLE, YOU STILL MAY OWE TAXES

In a firm or corporate liquidation, or when a shareholder redeems his or her interest, it's not uncommon for the business to distribute property as well as money in exchange for the capital stock a shareholder held.

When such a business distributes its property, it generally is deemed to have sold the property at fair market value, which requires it to recognize a gain (IRC section 336(a)). The shareholder, who treats the fair market value of the property as received in exchange for his or her stock, also recognizes a gain (IRC section 331(a)). The critical issue for tax planning is whether the assets distributed are considered property under IRC section 336 and whether the corporation owns them.

In a professional practice, tangible property such as office equipment, furniture and fixtures makes up a small portion of a firm's total value. By far the largest element of value in a profitable professional practice is the intangible goodwill. There's little doubt that distributions of the tangible property to shareholders in a liquidation are taxable under section 336. The corporation recognizes income on the excess of fair market value over adjusted basis. The shareholders recognize capital gains on the fair market value of the property received in excess of their basis in the stock.

But what about distributions of the business's intangible property and goodwill? The Tax Court has held goodwill to be a vendible--and taxable--asset that can be sold with a professional practice (LaRue v. Commissioner, 37 TC 39, 44 (1961)).

According to the IRS, when a corporation distributes "clients and customer-based intangibles" to its shareholders, IRC sections 331 and 336 apply; such intangibles include the corporation's client base, client records, workpapers and goodwill (including going-concern value). The IRS position is that these intangibles are the firm's assets and the firm realizes taxable gain when it distributes them to shareholders. Further, according to the IRS, when the firm transfers such intangibles to shareholders, they also realize taxable gain.

NO AGREEMENT, NO TAXABLE EVENT?

There's no doubt that a firm can distribute tangible property to its shareholders as a dividend, whether it liquidates or not. But a question arises when it distributes to its shareholders all its assets--both tangible and intangible--and ceases doing business: Is there a taxable distribution of its intangible goodwill? According to the IRS, the answer is yes. According to the Tax Court, on the other hand, I the answer is that it depends. The question of who "owns" the client relationships and customer-based intangibles turns on whether an employment or noncompete agreement is in effect at the time of the distribution.

The Tax Court has held that in the absence of an effective employment or noncompete agreement at the time of liquidation distributing customer-based intangibles to the shareholders is not a taxable event to either the corporation or to the individuals (Norwalk v. Commissioner, TC Memo, 1998-279). (See "In Real Life, Sometimes the Good Guys Win," at right.)

The Tax Court says that without an employment agreement or noncompete covenant, client goodwill attributable to a shareholder's personal characteristics isn't a property right belonging to, or transferable by, a firm.

For this reason, a business's liquidation plan should include the step of examining all employment agreements with shareholder-employees to identify noncompete provisions. Where such agreements exist, the practitioner should recommend to clients or employees that the agreements be rescinded before the liquidation. Under current case law, if such agreements are not effective at the time of the distribution then there should be no taxable event.

WHO OWNS INTANGIBLE ASSETS?

The Tax Court has long recognized that personal relationships of a shareholder-employee are not corporate assets where the employee has no employment contract with the corporation. Those personal assets are distinct from the intangible corporate asset of goodwill. In Estate of Taracido v. Commissioner, 72 TC 1014, 1023 (1979), the court found the sole shareholder essential to the corporation's success, but that the corporation's goodwill did not include the personal qualities of its sole shareholder. In Cullen v. Commissioner, 14 TC 368, 372 (1950), the court held that the personal ability, personality and reputation of the sole active shareholder, in the absence of an employment agreement, were not corporate intangible assets. In MacDonald v. Commissioner, 3 TC 720, 727 (1944), the court found no authority to hold that an individual's personal ability is part of the intangible assets of a corporation if it does not have a contractual or other right to his or her future services.

According to the Tax Court in Martin Ice Cream Co. v. Commissioner (110 TC 189 (1998)), it was Arnold, personally, and not Martin Ice Cream Co. or Arnold's new company, that owned the distribution rights that were sold to Haagen-Dazs. The Tax Court said, "The benefits of the personal relationships developed by Arnold with the supermarket chains and Arnold's oral agreement with the founder of Haagen-Dazs were not assets of Martin Ice Cream Co. that were transferred to Haagen-Dazs; Arnold was the owner and seller of those assets."

Many employment agreements contain noncompete provisions and declare clients and customers to be a "property right" of the corporation. Although some say "Clients or customers belong to the employer and not the employee, and the employer shall be the sole arbiter of work assignments and work quality," such provisions may not be binding in some states.

SO WHEN IS GOODWILL TRANSFER TAXABLE?

It isn't clear from the Tax Court's reasoning when a distribution of customer-based intangibles becomes a taxable event. Of course, the IRS interprets IRC sections 331 and 336 to include the distribution of intangible assets in all cases, but a sequence of Tax Court decisions does not provide a bright line for practitioners to follow in handling their firms' sales or in advising a client.

Norwalk and Martin clearly suggest that without employment and noncompete agreements both the corporation and the shareholder avoid taxation, but it is unclear what the tax consequences would be if such agreements were in place (see "Wiggle at Your Peril, However ...").

Without a sales agreement that transfers rights to the employer, a question arises as to how a provision in an employment or noncompete agreement could convert clients or customers to a property right of the corporation--if the right legally belongs to the employee. According to the Tax Court, where the goodwill value is based on the relationships between clients and an individual, without an employment agreement such intangibles do not belong to the corporation.

Generally, to be enforceable, a noncompete covenant must reasonably reflect an employer's protectable interest in both the nature and the scope of the restraint on the employee. Although trade secrets, special processes, patents and proprietary information are among an employer's protectable interests, it isn't clear how noncompete provisions create an employer property right to clients or customers if one did not previously exist.

According to the Tax Court, the corporations in Norwalk and Martin never owned the clients or customers and therefore could not transfer them in liquidation or otherwise. If the Tax Court is correct that the client relationships belonged to the individual accountants in Norwalk, how does any employment or noncompete agreement serve to transfer ownership from an individual to a corporation? It's unclear. Further, it is doubtful that' legal ownership of such an intangible property can effectively be transferred in any event, as clients can change their accountants or lawyers at any time.

REASONS TO RESCIND NONCOMPETES

It appears neither the corporation nor the shareholder will realize gain on the distribution of customer-based intangible assets if no employment and/or noncompete agreement exists when liquidation takes place. If the intangible value of client and customer relationships belongs to the individual providing the personal relationship, then the corporation's distributions of clients or customers and any contracts with these individuals are not taxable events.

The key to avoiding income tax for both the corporation and the individual shareholder centers on this aspect. Before owners liquidate any business or professional practice, it is critical that they rescind or void any employment or noncompete agreements. Clearly a practitioner should advise a client to dissolve noncompete agreements with shareholders before liquidation.

Terminating employment agreements benefits both the employee and the employer. So long as there's a genuine business purpose in taking such action, the IRS will likely be unable to discredit the transaction as an action made solely for tax purposes. In a complete liquidation, for example, to prohibit competition against a defunct entity is irrelevant, and releasing the employee from such an agreement is a benefit that can be negotiated as part of the termination arrangement. In the redemption of a single shareholder's interest, to terminate a noncompete agreement can benefit the employer by removing any employment obligation and obtaining a release from future lawsuits. These are bona fide business purposes that such a rescission may serve, irrespective of tax considerations.

GOOD PLANNING COVERS SEVERAL CONTINGENCIES 

The law is unclear and making arguments in Tax Court can be expensive. What is clear is that the IRS has taken a hard line position on taxing all distributions from a firm or corporation to its shareholders. When intangible assets such as client, customer, and contractual relationships and similar intangible goodwill have been distributed, the IRS has been quick to assess tax on the value of such property rights. There's little doubt the service will seek to tax any and all such distributions, whether a corporation is in liquidation or not.

Under present law, code sections 331 and 336 provide the IRS with ample authority to assess such tax at both the corporate and the individual shareholder levels.

Although the Tax Court dismissed the IRS assertions in the recent cases of Norwalk and Martin, no one knows how many assessments have gone unchallenged in court because of confusion about the law's application.

The Tax Court may have carved out a somewhat safe harbor for the distribution of customer-based intangibles to shareholders. This safe harbor depends on the absence of any employment or noncompete agreement at the time of the distribution. However, the court may require such distributed intangibles to have a value related to the shareholder's personal relationships with clients. It isn't clear how the Tax Court would treat distributions of clients not served by a particular individual--for instance in situations where staff other than the shareholder developed all the personal relationships.

Although specific procedures cannot be set forth with black letter rules, a careful reading of the Tax Court decisions suggests that businesses need to carefully document a liquidation plan. Such documentation should state that any existing employment and noncompete agreements are being terminated for a separate and mutual consideration. It should specifically acknowledge that the customer-based intangibles being distributed are the property of the shareholders and the corporation was entitled to benefit from them only as long as it employed the shareholder.

CONCLUSION

The cases discussed in this article point to parallels between CPA firms and commercial organizations when identifying the individual ownership of customer-based intangibles. Where CPAs plan a liquidation of their professional practice or wish to advise clients about dissolving their businesses, the solution to problems surrounding the issue of goodwill ownership is likely to be quite similar--terminate employment and noncompete agreements prior to liquidation.

Wiggle at Your Peril, However ...

The Tax Court's reasoning in Norwalk--that without an employment or noncompete agreement a distribution of "customer-based intangibles" isn't a taxable event, although the contrary might be true if such an agreement was in effect--raises a few legal questions. Among them are these:

* Can an employment agreement create involuntary servitude? Obviously, it can't. Because the 13th Amendment to the U.S. Constitution prohibits involuntary servitude, an employee can terminate employment with a corporation at will. So how does such an agreement make his or her clients the property of a corporation?

* Does a penalty clause for breach create ownership rights? Employment agreements frequently contain a penalty clause requiring an employee, in the event he or she leaves a firm and takes clients or customers, to pay the firm, for a period of time, a percentage of the fees collected from those clients. The corporation has a proprietary right, but no more, to bring an action to recover such money. The employment agreement, per se, does not make the client corporate property.

* Do noncompete agreements create ownership rights? Many employment agreements contain noncompete provisions together with a penalty clause for any breach of the agreement. Again, it appears the proprietary right of the employer is the contractual right to sue for money in the event of breach. Ownership of clients or customers isn't even the subject of the agreement.

* What's the tax result where the employment or noncompete agreement is void under state law? Although many states allow noncompete agreements, they generally specify a reasonably short time period and permit only a narrow geographical restraint on where the employee may compete against the former employer. Some state statutes imply that restrictive covenants are contrary to public policy, with language such as "all contracts ... which tend to lessen full and free competition ... are declared to be against public policy, unlawful and void." In California, for example, "except as provided ... every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void" (California Business and Professional Code, section 16600 (West 1987)). It seems inappropriate that federal tax consequences could turn on an interpretation of state employment law and result in inconsistent applications of federal tax law.

ALAN ZIPP, CPA, ABV, JD, practices tax law based in Rockville, Maryland. He is the author of RIA's Divorce: Valuation, Tax, and Financial Strategies and is an AICPA discussion leader for corporate and individual income tax workshops. His e-mail address is [e-mail].

In Real Life, Sometimes the Good Guys Win

Consider the case of William Norwalk and Robert DeMarta when they liquidated their Fremont, California, CPA firm and traded the equipment, office furniture and their client list to a large regional firm in exchange for a partnership interest. The IRS determined their firm had realized a $588,000 gain on liquidation of its goodwill and Norwalk and DeMarta, as shareholder partners, realized capital gains from the distribution of the goodwill.

The IRS said the distribution of clients was a taxable event. The IRS argued that when the corporation was liquidated, it distributed to its shareholders "customer-based intangibles" in addition to tangible assets. The intangible assets at issue included the corporation's client base, client records and workpapers and goodwill (including going-concern value). These intangibles, the IRS said, were corporate assets that had a specific value and when distributed to the shareholders in the liquidation, triggered taxable gains for both the corporation and the shareholders.

The CPAs said the corporation didn't own the clients. The CPAs argued that the corporation did not own the intangibles in question. The accountants themselves owned the intangibles, they said, and therefore no tax was attributable.

Agreements said that clients were assets of the corporation. Prior to the liquidation, the firm had had employment and noncompete agreements with the shareholders, which said, "Employee recognizes and acknowledges that the list of the corporation's clients, as it may exist from time to time, is a unique asset of the corporation's business." The agreements prohibited disclosure of the identity of the clients, barred the employee from performing services for clients outside the firm and set forth penalties for breach of these provisions.

The Tax Court ruled the liquidation not taxable because agreements had lapsed. At the time the firm liquidated, the agreements had expired and it did not have any effective employment or noncompete agreements with the two shareholders. Because of this, the Tax Court held that the distribution of the client base to the shareholders did not result in a taxable event to either the corporation or to the individuals.

The court found that client lists and goodwill have no "meaningful value" absent an effective noncompete agreement: "Because there was no enforceable contract which restricted the practice of any of the accountants at the time of the distribution, their personal goodwill did not attach to the corporation. Any goodwill transferred to the partnership was that of the individual accountants, not the corporation. Under these circumstances, we conclude that the value of any `customer-based intangibles' that the corporation may have had was nominal" (Norwalk v. Commissioner, TC Memo, 1998-279).