9030 / How is “goodwill” important in valuing small business interests?
Goodwill is an intangible business asset that includes attributes such as the business’ reputation, client and supplier relationships and potential for repeat business. In the closely-held business context, IRS Revenue Ruling 59-60 specifically identifies goodwill as a factor that must be valued in order to determine the company’s overall fair market value.
An important consideration in determining the presence of goodwill, and whether this goodwill is transferable, involves whether the general performance of the business depends upon a certain individual or a group of individuals. If this is the case, this goodwill may be lost if the business is sold without the continued participation of these individuals. Reduction in the value of goodwill can be exacerbated if those individuals not only leave the business, but also begin to compete against it. In the case of Norwalk v. Commissioner, a Tax Court case involving the liquidation of an accounting practice, the Court said that “[i]t is well-established …that the transfer of the ‘goodwill’ of a professional practice generally requires an enforceable covenant not to compete in order to be fully effective”1
Though the IRS has recognized that the personal skill of one owner or a group of owners often cannot (or will not) be sold along with the business,2 it has recognized that such skill can add substantially to the value of the business by enhancing the reputation of that business.3 However, in order for the value of the business to be increased by the goodwill established by departing business owners, the IRS requires that those departing owners relinquish all rights to that goodwill. Therefore, for example, if a business owner or group of owners sell their business without allowing the purchasers to use their existing business name, no goodwill has been transferred that would increase the value of the business.4
1. See Zorniger v. Comm., 62 TC 435 (1974); Akers v. Comm., 6 TC 693 (1946); Norwalk v. Comm., TC Memo 1998-279.