Avoiding the “Immediate Tax vs. Installment Payments” Mismatch by Carving Out Personal Goodwill

Introduction

When an S corporation owner (e.g., a father) wants to sell the entire business to his child (the son) using installment payments, common tax structures—like IRC §336(e) or §338(h)(10) “deemed asset sales”—often force immediate recognition of the entire built‐in gain, creating a cash‐flow mismatch. The father ends up paying a large tax bill in the year of sale, even though he collects the bulk of the purchase price from his son over many years.

Goal: Keep the same S corp entity (so the son doesn’t need to re‐paper contracts or form a new entity), grant the son a stepped‐up basis for at least a portion of intangible assets, and let the father defer some gain in line with the actual installment payments.

A personal goodwill carve‐out can be a good solution if much of the business’s value truly resides in the father’s personal relationships, reputation, and know‐how. By isolating that intangible as belonging to the father—not the S corp—he can sell that goodwill directly to the son on an installment basis, deferring gain recognition and avoiding the big “upfront tax” mismatch.

The Common Problem: Mismatch Under §336/§338

A. Inside vs. Outside Sales

• Outside (Stock) Sale: Father sells stock to the son via installment, which would normally allow the father to recognize gain proportionally as payments are received.
• Inside (Deemed Asset) Sale: If we elect §336(e) or §338(h)(10) to step up the basis of the S corp’s assets, the tax code pretends the S corp sold everything at fair market value right away—triggering 100% of the built‐in gain in Year 1

Mismatch: The father (seller) faces immediate tax on the entire appreciation, yet the son is paying over multiple years. This is great for the son (who gets a stepped‐up basis immediately) but creates a substantial cash‐flow headache for the father.

The Proposed Solution: Personal Goodwill Carve‐Out

Martin Ice Cream Doctrine: The courts have recognized that certain business “goodwill” can belong to the individual if it is not actually owned or assigned to the corporation (e.g., no non‐compete or employment agreement transferring it). If the father has unique personal relationships or personal branding that the S corp cannot claim, that intangible is father’s personal property.

1. Dad Sells Personal Goodwill to Son on Installment

   • The father and son create a Purchase Agreement specifically for that personal goodwill, financed with a promissory note (installment schedule).
   • Father reports gain under IRC §453, recognizing it as payments come in.
   • This defers capital gain, aligning tax recognition with actual cash flow.

2. Son Contributes Goodwill into the S Corp

   • The son, now owning that goodwill, transfers it into the S corp (in exchange for new shares or as a capital contribution).
   • The S corp receives a stepped‐up basis in that intangible, allowing amortization over 15 years.

3. Remaining S Corp Stock Sale

   • The father sells his S corp shares to the son for whatever remaining value the corporation holds (e.g., tangible assets, any intangible actually owned by the corp).
   • Because the biggest piece of intangible is carved out, the father might have a smaller or simpler stock sale. If father does no deemed asset sale election for these other assets, there’s no forced recognition of all corporate gains at once.

Outcome:

• The father defers gain on the personal goodwill portion in step with payments.
• The S corp remains intact.
• The son obtains an amortizable basis in the personal goodwill.
• Any corporate assets that remain still have their old basis unless the parties do a separate structure or election for that portion.

Mechanics: Step by Step

1) Identify True Personal Goodwill

• Verify father’s intangible is not locked up in corporate non‐competes or assigned via employment contracts.
• Often, if the business depends heavily on the father’s personal relationships, specialized skill, or personal brand, that intangible can rightfully be “personal” under the “Martin Ice Cream” rationale.

2) Valuation

• A professional or internal valuation must allocate intangible value between the father’s personal goodwill and any “enterprise goodwill” belonging to the S corp.
• The father’s personal goodwill must be carefully documented to withstand IRS scrutiny—particularly in a family/related‐party context.

3) Draft an Installment Sale Agreement (Father → Son)

• Terms: principal amount, interest rate, payment schedule.
• Father recognizes long‐term capital gain on a pro rata basis as principal is received (Form 6252 on father’s 1040).
• This solves the mismatch problem for that chunk of intangible value.

4) Son Contributes Goodwill to the S Corp

• Son can exchange the intangible for additional stock or simply contribute it as paid‐in capital, giving the S corp a new, stepped‐up basis in the intangible.
• The S corp begins 15‐year amortization under IRC §197.

5) Stock Sale of Remaining S Corp

• The father sells his S corp shares to the son for the business’s remaining net value (tangible assets + any intangible the corp truly owns).
• If father wants no further “deemed sale” at the corporate level, do not do a §336(e) or §338 election for this part. The father can do a simpler outside stock sale.
• The father might do a small separate installment note for the stock, or a lump sum, depending on the leftover value.

When Does This Make Sense?

1. Dominant Personal Goodwill: If the company’s main value is father’s personal brand/relationships, this approach helps align tax recognition with installment payments.
2. No Need for Full Corporate Asset Step‐Up: You only step up the intangible that father personally owned. Other S corp assets remain at old basis. If the father is comfortable with that, it avoids the big immediate corporate‐level gain.
3. Long‐Term Relationship: The father and son likely want to preserve the same S corp to avoid re‐papering client contracts and keep continuity.
4. Audit Preparedness: You can demonstrate the father’s intangible is truly personal, not corporate property, to avoid IRS recharacterization.

Pros & Cons

Pros

• Defers Tax: The father pays capital gains tax on the personal goodwill as payments are actually received.
• Amortizable Intangible: Son contributes the goodwill to the S corp, which can amortize it over 15 years, reducing future taxable income.
• Continued Corporate Existence: No new entity formation; same S corp EIN and contracts.

Cons

• No Full Asset Step‐Up: Corporate assets that are not father’s personal goodwill remain at old basis.
• Valuation & Documentation: Must provide solid evidence that the goodwill belongs personally to the father, which can be challenging in a family deal.
• Partial Mismatch: If there is still large intangible inside the S corp, and a separate election is made, it might still trigger immediate gain.
• IRS Scrutiny: Related‐party intangible allocations get extra attention.

Indicators That “Most” of the Business Is Personal Goodwill

1. Customer Ties to the Father: Client loyalty is primarily to Dad’s expertise or personal relationships, not the corporate brand.
2. Minimal Corporate Infrastructure: The S corp may have no marketing IP, brand assets, or intangible processes distinct from Dad’s personal skill.
3. No Employment Contracts: If Dad never assigned intangible property (e.g., via a non-compete) to the corp, it supports personal goodwill.
4. Potentially No Real Value Without Dad: If removing Dad from the equation would drastically reduce the business’s value, this points to personal goodwill.

Conclusion

The personal goodwill carve‐out is a strategic method to avoid the immediate tax mismatch typically seen in §336/§338 stock-to-asset transactions when the father finances the purchase for the son over time. While it does not provide a global step‐up on all assets, it addresses the father’s cash-flow concern by aligning tax recognition for that intangible with actual payments. The S corp continues uninterrupted, and the son can amortize the contributed goodwill over 15 years.

Key Action Steps:

1. Verify Personal Goodwill: Document that father never formally transferred relationships/skills to the S corp.
2. Obtain Valuation: Reasonably allocate intangible value between personal goodwill vs. any corporate intangibles.
3. Set Up Installment Sale for father’s personal goodwill; father recognizes gain gradually.
4. Son Contributes Goodwill to the S corp, enabling amortization.
5. Sell S Corp Stock for the leftover business value, preserving the entity.

Although it does not yield a universal inside step-up, it may be the optimal compromise—the father defers the lion’s share of intangible-based gain, the son obtains some immediate intangible basis, and the S corp remains intact with minimal re‐papering. Careful documentation, consistent valuations, and awareness of IRS scrutiny are essential to ensure a smooth transaction and secure the intended tax benefits.

Joe is  a Certified Public Accountant (C.P.A.) and a Certified Valuation Analyst (C.V.A.). Joe’s professional career in public accounting began in 2012 with one of the “Big 4” international accounting firms. Since 2012, the focus of his professional engagements has been primarily in the area of business tax planning, cash flow planning and management, business valuations, and small business financial consulting.