Gift formula valuation clause. In December 2009 (Vol. 4. No.3), we reported on the Petter case, where the taxpayer made sales and gifts of limited liability company units to trusts for her daughters and to a charity. The terms of the transfer provided that the number of units that were to go to the daughters' trusts was the number of units whose value, as finally determined for tax purposes, was not in excess of a fixed sum that would not cause the taxpayer to become liable for gift taxes. The entire balance of the units went to the charity. Upon audit, the IRS established a higher value for the units than was used by the taxpayer. The taxpayer claimed an additional charitable contribution deduction for a larger gift to the charity and the IRS disallowed that deduction. The Tax Court held in the taxpayer's favor.

The Tax Court's decision has now been affirmed by the United States Court of Appeals for the Ninth Circuit. This is important because cases of taxpayers residing in California are appealed to the Ninth Circuit. In these cases, the IRS always argues that formula clauses violate public policy because such a clause insures that a gift tax will never be paid on this kind of transfer. Neither the Tax Court nor the Ninth Circuit agreed with the IRS on this point, although the Ninth Circuit did invite the IRS to amend its regulations if it wishes to change this result.

In August (Vol. 6 No. 2), we reported on the Hendrix case, where the Tax Court once again approved the use of a formula valuation clause. Similar to the facts of Petter, any excess value above a stated amount was to go to a charity. So far, taxpayers are prevailing where the excess valuation amount goes to a charity (McCord, Petter, Hendrix). The IRS, however, has prevailed where the excess value amount is returned to the donor (Procter, Ward).

Personal goodwill. Personal goodwill has become an important asset for tax planning purposes. In August 2010 (Vol. 5 No. 2), we reported on the case of Larry E. Howard v. United States. Dr. Howard was a dentist who practiced through a professional corporation. When he sold his practice, the corporation received $47,100 for its assets while Dr. Howard individually received $549,000 for personal goodwill and $16,000 for a covenant not to compete.

Corporations are not tax efficient in sale transactions because the buyer always wants to purchase the assets of the corporation so that it can allocate the purchase price to assets that can be depreciated or amortized for tax purposes. The sale of assets by a C corporation, however, results in both corporate level tax on the sale, as well as a second tax at the shareholder level when the corporation distributes the after-tax sales proceeds to the shareholders. It is more efficient for the shareholders simply to sell their stock and pay a single capital gain tax on the proceeds.

Tax advisors have attempted to get around this problem by claiming that the selling shareholder is possessed of "personal goodwill;" an intangible asset owned by the selling shareholder, but critical to the business of the corporation. An example might be relationships with key clients or customers that are important to the business. In Dr. Howard's case, the goodwill was his personal relationship with his patients.

The District Court held that the goodwill was an asset of the corporation which should be treated as though it sold the goodwill and then distributed the proceeds to Dr. Howard. The Ninth Circuit has now affirmed the District Court. In the view of the Ninth Circuit, Dr. Howard was tripped up by the employment agreement he had with the corporation. The agreement required Dr. Howard to render his full-time dental services to the corporation and prohibited him from competing with the corporation for three years after his employment terminated. The corporation retained full control over the acceptance of new patients and ownership of patient records. The court held that Dr. Howard had transferred the economic value of his patient relationships to the corporation.

It is interesting to think about whether Dr. Howard could have put himself in a better position. Suppose his employment had provided that he owned and retained the rights to any patient relationships he developed during the course of his employment? Since he was the only shareholder of the corporation, there was little economic risk in having such a provision in the employment agreement. While a provision of this nature may enhance the shareholder's position with respect to personal goodwill, it may also provide the IRS with a good argument that the income being received is really being earned by the shareholder and the corporation should simply be disregarded.

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