Larry E. Howard and Joan M. Howard, Plaintiffs v. United States of America, Defendant, U.S. District Court, E.D. Washington,2010-2 U.S.T.C. ¶50,542, (Jul. 30, 2010) is a new case re-emphasizing the factors established in Martin Ice Cream and Norwalk. Howard involved the sale of an incorporated dental practice whose owner (Howard) had, perhaps inexplicably, entered into a 3-year post-employment noncompete agreement with his corporate practice. The Court found that the goodwill of the practice was owned by the corporation, not Howard personally, and that the sale proceeds attributed to that goodwill resulted in a dividend to Howard and a tax of $60,129, together with interest of $14,792.
The Court stated "In order to resolve issues of tax liability arising from legal interests, the Court must look both to state law for the determination of the legal interest and federal law for the taxation of the interest." As I have maintained in the years since Norwalk and my articles in CPA Expert and BVR's Guide to Goodwill Valuation and various conference and seminar appearances, analysis of state law remains a critical component of any valuation of a noncompete agreement - whether it be for tax purposes, damages purposes or, in most circumstances, marital dissolution purposes. The new edition of AHLA/BVR's Guide to Healthcare Valuation includes several chapters written by me addressing both the valuation of enterprise and personal goodwill along with noncompete agreements, as well as damages from the violation of noncompete agreements. http://cpa.net/?page_id=427
I will observe that the Court cited "MacDonald v. Comm'r 3 T.C. 720, 726, 1944 WL 121 (1944), for the proposition that if an employee works for a corporation under contract and with a covenant not to compete with that corporation, as Dr. Howard did, then the corporation, and not the individual professional, owns the goodwill that is generated from the professional's work" a case that I would have regarded as "history" after Martin Ice Cream. The Court also discussd that "the Furrer court divided an employee's goodwill as goodwill for his company, and separately, goodwill for himself, “such as personal contacts … .” Furrer v.Comm'r 566 F.2d 1115, 1117-1118 (9th Cir. 1977).
Citing Norwalk, the Court observed "“In determining the value of goodwill, there is no specific rule,and each case must be considered and decided in light of its own particular facts. Moreover, in determining such value it is well established that the earning power of the business is an important factor.” This reminds us that cases are very fact-specific.
Finally, the Howard Court concluded "Bound by the covenant not to compete with Howard Corporation for a period of three years beyond when Dr. Howard no longer held Howard Corporation stock, which was until the dissolution of the Howard Corporation at the end of 2003 ( see Ct. Rec. 28, Ex A at 28), Dr. Howard could not have earned income from a competitive dental practice within fifty miles of Spokane (Ct. Rec. 28, Ex F). Therefore, even if the goodwill had belonged to Dr. Howard personally, it likely would have little value, because Dr. Howard could not have practiced within a fifty mile radius from his previous practice location for at least three years beyond the date of the Howard Corporation dissolution. Those prohibitions would likely discourage patients from following Dr. Howard to a new location."
The New AHLA/BVR Guide also addresses related reasonable compensation issues related to goodwill and the "independent investor" test of Exacto Spring (Seventh Circuit Ct. of Appeals, No. 99-1011 reversing T.C. Memo 1998-220)
Note: See also Technical Advice Memorandum 200244009.
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