The Ninth Circuit Court of Appeals recently upheld the District Court in Howard v. United States. In 1980, Howard incorporated his solo dental practice. At the time, Howard also executed a covenant not to compete ('CNTC")with his own corporation. I don't know what risk Dr. Howard was attempting to mitigate; and in retrospect it may have been in his best interest, considering his circumstances. However, as it turns out, this did not play out very well as an income tax avoidance strategy.
Thirty years later, Dr. Howard sold his practice and allocated nearly $550,000 to his personal goodwill and treated it as capital gains on his federal tax return. Arguing that the CNTC transferred Howard's personal goodwill to the corporation, the IRS re-characterized the $550,000 as a dividend, subject to tax as ordinary income. From an income tax standpoint, the implication is clear.
However, the precedent is a good deal murkier with respect to marital dissolution. The majority of states currently hold that personal (a/k/a professional) goodwill is not subject to inclusion in marital property. The McReath divorce case in Wisconsin introduced transferable goodwill as the amount included in marital property. CNTC's may become instrumental in characterizing personal goodwill as transferable; and, thus includable in the marital estate. Of course, if this becomes the norm, the pendulum will swing to assessing reasonable compensation and avoidance of double-dipping on alimony.
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