Sole shareholder can receive employment agreement payment on sale of business rather than corporation because shareholder sold his good will

In H&M, Inc. v. Commissioner, T.C. Memo 2012-290 (2012), the United States Tax Court determined that where a corporation sold its insurance brokerage while its sole shareholder entered into employment with the buyer, the compensation under the employment agreement was not a disguised purchase price payment to the selling corporation.  The Tax Court determined that the shareholder's personal ability and other individualistic qualities were not a corporate asset (goodwill) that should be taken into account as part of the purchase price.

By way of background, the sale of a business often involves the transfer of intangible assets.  These assets can constitute the goodwill of the business, a corporate asset and the shareholder's agreement not to compete with the buyer along with an arrangement for the shareholder to provide future services.  Two seminal Tax Court cases permit payments to shareholders rather than corporations thereby precluding double tax treatment.  Martin Ice Cream Co v. Comm., 110 T.C. 189 (1998), (personal relationships of a shareholder-employee aren't corporate assets where the employee has no employment contract with the corporation); MacDonald v. Comm., 3 T.C. 720 (1944) (a corporation did not have any goodwill in the shareholder's personal ability, business acquaintanceship, and other individualistic qualities).

The Tax Court in H&M held that, in light of the shareholder’s personal relationships, his experience in running all facets of an insurance agency and his responsibilities as manager of the bank's insurance agency, the compensation that the bank paid him was reasonable. The employment agreement contained an extensive list of duties that the shareholder’s was required to perform. Not only was the shareholder an insurance salesman, he also had significant management and bookkeeping responsibilities. He went from working around 40 hours per week before the sale to double that afterward.  As such, the H&M Court found the case to be akin to MacDonald and Martin Ice Cream Co. The Court specifically found that when customers came to the shareholder’s agency, they came to buy from him. It was the shareholder’s name and his reputation that brought them there. The Court further found that he had no agreement with H&M at the time of its sale that prevented him from taking his relationships, reputation, and skill elsewhere.

The H&M case provides ammunition to attorneys who structure transactions to avoid double tax on the sale by the selling shareholder entering into an employment agreement with the purchaser.