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How Sale of Business Can Generate Ordinary Income

Why IRS re-characterized capital gains as ordinary income and assessed deficiencies.

January 2011
by Charles Reichert/Journal of Accountancy

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 percent 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 percent was allocated to KCG for its client list and non-compete agreement. After about 18 months of working under this arrangement, Kennedy felt he was undercompensated and negotiated a salary in addition to the payments.

Pursuant to the purchase agreement, Kennedy received $176,100 and $32,758 from M&P in 2001 and 2002 respectively and reported each amount as long-term capital gain from the sale of goodwill on the joint returns he and his wife filed. Kennedy had unrelated capital losses that offset all of the 2002 gain and all but $2,442 of the 2001 gain.

The IRS re-characterized the capital gains in both years as ordinary income and assessed deficiencies and accuracy-related penalties totaling $87,989 against Kennedy and his wife on their joint returns. The Kennedys petitioned the Tax Court for relief.

This article has been excerpted from the Journal of Accountancy. View the full article here.