The Dental Lawyer | Entities and Practice Sales: Howard v. United States

In a previous post I mentioned that if there is any intention to sell a practice that said practice should not be taxed as a c-corp (note that when a corporation is formed you have the option, presuming you meet certain requirements, to be taxed as an s-corp or a c-corp).  This suggestion comes as a result of the 9^th Circuit’s decision in Howard v. United States, 448 Fed. Appx. 752; 2011 U.S. App. LEXIS 18092; 108 A.F.T.R.2d (RIA) 5993.  

In Howard, a dentist sold his practice, a professional service corporation taxed as a c-corp (the “Corporation”), to a buyer.  When Corporation was formed owner’s attorney, rather thoroughly, put together an employment agreement with a covenant-not-to-compete along with the incorporating documents.  Dr. Howard entered into the employment agreement with the corporation, which said nothing about the ownership of goodwill.  In the Asset Purchase Agreement, Dr. Howard allocated $549,900 to personal goodwill and $16,000 to the a covenant not to compete with the buyer’s Corporation.  The remaining $47,100 was allocated to tangible assets. 

When the Howards filed their 2002 federal income tax return, they reported $320,358 as a long-term capital gain resulting from the sale of personal goodwill to the buyer.  The IRS, however, had other ideas, and after auditing Dr. Howard’s return, they re-characterized the goodwill as a corporate asset.  The implications of this cannot be understated.  If goodwill is treated as a personal asset, as Dr. Howard intended, the goodwill would be taxed once as a long term capital gain, a rate which is significantly lower than the high ordinary income rates which most dentists pay on their personal tax returns.  By being characterized as a corporate asset, the money allocated to goodwill would be taxed twice, once at the corporate level (that is, the corporation which was solely owned by Dr. Howard had to pay tax on the goodwill) and again when that money was distributed to Dr. Howard, as such a distribution would be treated as a dividend taxable to Dr. Howard personally. As a result, Howard was taxed twice at higher rates as opposed to once at a lower rate. 

The 9^th Circuit relied on Martin Ice Cream Co. v. Comm'r, 110 T.C. 189 at 207-08 (1998), Norwalk v. Comm'r, T.C. Memo 1998-279, 76 T.C.M. (CCH) 208 (1998), Macdonald v. Comm'r, 3 T.C. 720, 727 (1944), to reach the conclusion that when a C-corp has an employment agreement, with a restrictive covenant, entered into by the owner of the corporation, the corporation and not the individual owns personal goodwill.

Industry wide the advice given to avoid this double taxation conundrum is not to sell as a c-corp.  Read narrowly, one should only hit the double taxation problem if there is, (1) a Professional Service Corporation, (2) taxed as an c-corp, (3) where the doctor has an employment agreement with the corporation, and (4) where the employment agreement contains a covenant-not-to-compete. My feeling is, however, that this reading of the case is too narrow, and to avoid the issue dental practices should not be taxed as C-corps (there really are few benefits for most practices to be taxed as a c-corps anyways).

I would also add that I would not be surprised if in the coming years the IRS tries to use this precedent to expand the holding in Howard, to s-corps and partnerships.  As a result the best protection might be for OWNERS not to have employment agreements with their practices in any respect.  Owners, however, should make sure that any associate dentists they employ are bound by an employment agreement for a completely different set of reasons.