Personal Goodwill vs. Entity Goodwill: Understanding and Valuing the Differences

Personal goodwill issues often arise in valuation engagements and can be particularly contentious and confusing in cases of divorce. While any marketable goodwill from a business (typically referred to as enterprise or entity goodwill) represents value when dividing property between spouses, personal goodwill is often called into question. This is particularly true when one spouse has a professional occupation such as attorney, dentist, physician, architect or accountant. 

In these cases, it’s important to segregate personal goodwill from entity goodwill in order to identify marital assets. Keep in mind, however, that whether personal goodwill can actually be part of marital assets to be divided varies by state.

When it comes to personal versus entity goodwill, knowing what’s accurate and acceptable starts by first recognizing the definition of goodwill. The following represents a sound definition:

“Goodwill has been described as the value of a business practice that exceeds the combined value of the net assets used in the business. Goodwill in a professional practice may be attributable to the business enterprise itself by virtue of its existing arrangements with suppliers, customers or others, and its anticipated future customer base because of factors attributable to the business. It may also be attributable to the individual owner’s personal skill, training, or reputation. This distinction is sometimes reflected in the use of the term enterprise, as opposed to personal goodwill.”¹

Many factors affect personal goodwill and entity goodwill. To determine whether personal goodwill exists, what the worth actually is, and whether it can be transferable, the following factors² and questions must be considered:

• Earning power: Are normal earnings expected? If there are greater than normal earnings, are they obtained through goodwill?
• Reputation: Does the professional have a reputation in the community for judgment, skill and knowledge?
• Age and health: Is the professional relatively young and still in good health? If so, there will typically be more goodwill established.
• Work habits: Is the professional hardworking, diligent and conscientious?
• Duration of business: How long has it existed?
• Referrals diversity: Does one person at the company bring in all referrals?
• Location: Is the business in a prime location that more easily attracts clients?
• Size of business: Is the business relatively simple and operating under a sole practitioner, or is it complex, larger and has multiple revenue generators? Typically, as a company increases in size and complexity, goodwill can transition from being primarily personal to mostly entity related.
• Source of new clients: Are clients coming in because of the professional and their relationship to the business?
• Compensation: Is the professional’s income in an average range?
• Size of work force: Is the work force large or highly skilled, thus adding value to the entity?
• Competition: Does the entity have lots of competition, or does it “own” its market?

To illustrate the line between personal and entity goodwill, consider the following example:

Blue Corp. repairs ships for Queen Transportation, which constitutes 98% of its business. The company is owned equally by Harry, Vince and Sheila and is the sole supplier of these repair services at the Port of New York and New Jersey. Its business is obtained through purchase orders, and Blue Corp. relies on John Salesman to solicit them. There are no employment or noncompete agreements with John Salesman or purchase contracts with Queen Transportation. Blue Corp. relies solely on John for its sales.

Without John, is there any value to Blue Corp.? Without a noncompete agreement, what would happen to Blue Corp. if John went out on his own? This represents an example of personal goodwill, since the company relies entirely on John. 

Diving Deeper: How Personal Is Personal Goodwill?

Yet segregating personal versus entity goodwill requires an even deeper dive. In order to examine the issues surrounding personal goodwill more closely, it’s important to recognize that there are actually three different types of goodwill: entity goodwill, nontransferable personal goodwill and transferable personal goodwill.

A number of factors can constitute entity goodwill. They include the company name and the value inherent therein, the company phone number (think of those that spell out the business name), and the company location. A great location with high-traffic visibility, easy parking or walk-in traffic can equate to greater earnings.

Special attributes like trademarks, patents and trade secrets also contribute to entity goodwill, as does a highly skilled work force. In addition, going-concern value is also part of the equation, of which a certain amount is patronage. This is the value of the income stream and normal expected earnings based on the fact that the business is a longstanding one as opposed to a start-up.

Nontransferable personal goodwill is goodwill that cannot be transferred to the entity or to anyone else under any circumstance. An example would be specialized, nontransferable skills such as those a surgeon brings to his or her career.

It’s important to note that even a covenant will not assist in transferring the value of pure personal goodwill; it simply isn’t transferable.

Goodwill that is personal but can be transferred to either the entity or another person is considered transferable personal goodwill. It can include personal relationships, specialized knowledge about an industry or business, contact lists and client or patient relationships. Generally, transferring such goodwill consists of a process that occurs over time, as when the professional offers assistance throughout a transitioning period.

Personal Goodwill in a Commercial Business

In some commercial businesses, there is little to no personal goodwill. In others, the personal goodwill might be substantial. Two court cases illustrate both sides of this issue.

The first is Frazier v. Frazier.³ The business being valued was a single-location retail furniture store. While the propertied spouse’s attorneys claimed that most of the goodwill was personal, the facts were that very little of the value, if any, could be attributed to the owner. He did not have any special relationships with the customers, who came from the general public, and he had no special relationships with suppliers. 

While a buyer would insist on a noncompete agreement, it would really have value only to keep the owner from a “suicidal” attempt to compete in a nearby location. In this case, there was no real personal goodwill value; the entire goodwill was entity goodwill.

In contrast, an example of when there can be substantial personal goodwill in a commercial business can be found in the well-known tax case of Martin Ice Cream v. Commissioner, wherein the court held that the personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. 

“Those personal assets are entirely distinct from the intangible corporate asset of corporate goodwill.”⁴

The details of the case center on Arnold Strassberg, who in 1960 was a major distributor of wholesale ice cream products across the northeastern United States. In 1974, Strassberg was approached by the founder of Häagen-Dazs and asked to sell and distribute its premium ice cream in the retail market. 

Strassberg became Häagen-Dazs’ first distributor to supermarkets, and in the late 1970s, Strassberg’s son Martin, as owner of Martin Ice Cream, also began distributing Häagen-Dazs ice cream to major supermarket chains. Neither father nor son had written distribution agreements with Häagen-Dazs, only oral agreements.

In 1988 when Häagen-Dazs (then owned by Pillsbury) sought to acquire and terminate the oral agreement with both Arnold and Martin, the court ruled that the personal goodwill of Arnold Strassberg wasn’t part of company assets in the sale because it represented the shareholder’s personal relationships with supermarkets and was based on a handshake agreement with Häagen-Dazs. Important to the tax court decision was the fact that Arnold did not have a noncompete agreement or employment contract with the company.

As a result, the majority of a $1.4 million payment to Arnold Strassberg was determined to be personal assets of Arnold, as opposed to business assets. 

Segregating Goodwill

In the event of divorce, it’s important to distinguish between personal and entity goodwill and then determine which is and is not part of marital assets. Although there is no magic formula for determining the amount of personal goodwill, a good starting place is to determine the specific individuals who might have personal goodwill related to the business. 

As to the amount of personal goodwill related to each individual, they would require a further determination through a credible analysis. Engaging an entity that is thoroughly familiar with the complexities of goodwill and valuations is vital to securing accurate results and findings. If you would like to learn more about goodwill and how it may apply to your situation, contact Wipfli.