Goodwill: a personal matter

BVWireIssue #70-4
July 23, 2008

The recent decision by the U.S. Tax Court in Derby et al. v. Commissioner contains important information for appraisers who have clients in the healthcare industry.  Often, a medical practice has very few tangible assets, and the real value lies in goodwill and the covenant not to compete.  Mark Dietrich, CPA/ABV (Mark Dietrich, CPA, PC, Framingham, MA), a current member of the AICPA's Health Care Expert Panel, said that “Sometimes there is an assumption made by appraisers that non-competes are automatically included in the fair market value.  But if you are valuing for an actual transaction and the buyer and seller are writing a contract, you need to know the precise terms of the non-compete to assess what elements of goodwill and other intangible assets are included in the transactions, and that the non-compete lasts for a sufficient amount of time to warrant treating the valuation cash flows as perpetual.” 

In the case of Derby, the appraised value of the practice was $4 million, and the sale price was $1.2 million (the value of the hard assets, with the doctors in the practice receiving long-term employment with generous compensation packages).  The problem then was that the practice was sold to a nonprofit, and the sellers treated the difference in price as a charitable donation.  So the issue before the court was whether the petitioners were entitled to the charitable contribution deductions claimed under Section 170(a)(1) of the IRS Tax Code.  However, under that statute, no deduction can be taken if something is given in return (in this case, the value of the long-term employment and compensation package.  The actual compensation in the employment contracts was significantly greater than that used in the taxpayers’ valuation of the practice). Therefore, the U.S. Tax Court rejected the claim for the deduction. 

“I think it was about time that the courts revisited Norwalk and they do so in the Derby case.” Mark said. “Norwalk established that absent a contractual right, personal goodwill of a professional is not an asset of the corporation employing them, and can’t be transferred without a covenant not to compete to prevent them from taking their goodwill elsewhere.” 

For more information on key points in the Derby case, visit Mark’s blog here.

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