Explore the tax implications for sales representatives in business asset sales through a real case study. Learn about the challenges faced by an employee in categorizing sales proceeds as capital gains and the crucial court ruling that determined the nature of the termination payment.
M&A Stories
September 20, 2018
In a recent case, an employee of an Oklahoma-based business, specializing in soils, mulches, and decorative stone, faced a tax dispute regarding the treatment of sales proceeds. The story involves a sales representative (the taxpayer) who, despite a long-standing relationship with the business, encountered challenges in categorizing the proceeds from the sale as capital gains.
Background:
The taxpayer, employed by the business since the early 1990s, had a written compensation agreement as an independent sales representative. Notably, he was neither a shareholder nor an officer of the company. The agreement entitled him to commissions and a termination payment in the event of a sale or transfer.
The Sale:
In 2010, a large garden soil competitor headquartered in Atlanta, Georgia, and a subsidiary of a public Irish company, approached the seller for an asset purchase. The taxpayer, a crucial sales representative, was party to the purchase agreement. However, the buyer explicitly excluded certain liabilities, including termination payments owed to the taxpayer.
Tax Dispute:
Post-sale, the taxpayer reported the termination payment of approximately $1.7 million as the sale of goodwill, considering it taxable as a capital gain. The IRS disagreed, arguing it should be treated as ordinary income subject to self-employment tax.
Court Ruling:
The Tax Court determined that the taxpayer did not sell any assets to the buyer or the seller. The crucial factor was that the relationships fostered by the taxpayer were with the seller’s clients, and these client contacts were not his to sell. Consequently, the 2010 termination payment was deemed ordinary income for the right to service the seller’s clients, not the sale of goodwill.
Conclusion:
This case highlights the importance of understanding the nuances of goodwill in business asset sales. While owners may treat payments as goodwill in specific scenarios, sales representatives must carefully navigate such situations. The Potter v. Commissioner of Internal Revenue case serves as a reminder that personal relationships alone may not suffice to classify proceeds as capital gains, especially when the seller is not the owner.
Case Reference:
Potter v. Commissioner of Internal Revenue, Docket Nos. 4972-14, 5754-14, United States Tax Court (Filed September 17, 2018).
By John McCauley: I help people start, grow, buy and sell their businesses.
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