In 1980, Larry Howard, DDS, incorporated his practice, becoming the sole shareholder, officer, and director. He also entered a covenant not to compete (in effect, protecting his company from himself). Whatever his objective, when he retired in 2002 and sold his practice to another “corporate” dentist, the parties’ purchase agreement allocated nearly $550,000 to Dr. Howard as personal goodwill and $16,000 for the covenant not to compete. In filing his federal income tax returns that year, Dr. Howard reported just over $320,000 as long-term capital gain resulting from the sale of goodwill. The IRS characterized the goodwill as a corporate asset, however, and treated the dentist’s receipt of $320,000 as a dividend.
On review by the federal district court (E.D. Wash.), the taxpayer relied on state divorce law to argue that professional goodwill was a personal asset. Moreover, the purchase agreement had classified it as such and the sale of the company effectively terminated the non-compete. By contrast, the IRS cited Tax Court cases to show that if an employee works under a covenant not to compete, then the company owns the goodwill generated from the professional’s work—and the court ultimately agreed. “The covenant not to compete reinforces the conclusion that Howard Corporation controlled the assets, earned the income from Dr. Howard’s services, and barred Dr. Howard from competing with Howard Corporation.”