Personal goodwill and the one line in the purchase agreement that moves the tax

You are selling a professional practice for $3.2 million and your attorney sends the purchase agreement to review. Six pages in there is a schedule allocating $400,000 to equipment, $600,000 to a covenant not to compete, and $2.2 million to goodwill. You sign it. The allocation determines whether portions of the sale are taxed as capital gain at 23.8 percent or ordinary income at rates that can reach 39.9 percent, and the mistake is now permanent.

The purchase price is not one tax number. It is several, and which category each dollar lands in decides the tax rate. The allocation across equipment, covenant not to compete, enterprise goodwill and personal goodwill is negotiable. It is written into the purchase agreement as a schedule, and both sides sign it. What happens after that signature is that sellers discover the tax consequence of a negotiation they may not have realised they were having.

The tax turn on one line

Section 197 of the Internal Revenue Code requires a buyer to amortise goodwill and most other intangibles over fifteen years. The buyer wants as much of the price as possible in categories that produce a deduction — equipment they can depreciate quickly, a non-compete they can amortise, goodwill they can write off over fifteen years. The seller wants the opposite: as much as possible treated as capital gain under Section 1221, which in 2025 tops out at 20 percent plus the 3.8 percent net investment income tax.

A covenant not to compete is ordinary income to the seller. It is compensation for agreeing not to work, so it is taxed the way salary would be. For a seller in the top bracket that is 37 percent federal. For a seller still subject to self-employment tax, the rate can reach 52.3 percent when the 15.3 percent self-employment levy applies to the first $176,100 allocated to the non-compete in 2025, or 39.9 percent on amounts above that threshold where only Medicare tax applies. The buyer gets to amortise that same amount over fifteen years under Section 197.

Goodwill that belongs to the company — the reputation of the business, its location, its systems, its referral base — is enterprise goodwill. That is a capital asset. Sold by a C corporation it is taxed once at the corporate level, currently 21 percent, and again when distributed to the shareholder. Sold by an S corporation or an LLC it is taxed once as capital gain to the owner.

Goodwill that belongs to the individual — the relationships the owner built, the reputation that follows them rather than the business, the clients who came because of who they are — is personal goodwill. It is not owned by the company, so it is not sold by the company, and the corporation's balance sheet never sees it. The owner sells it separately and reports it as an individual capital gain. Whether that structure holds depends on whether the personal goodwill was in fact never transferred to the corporation and whether the purchase agreement describes it that way.

Personal goodwill only exists if the agreement says it does

Personal goodwill is not something a seller can declare after the transaction closes. The purchase agreement allocates the price, both parties sign the allocation, and Section 1060 generally requires them to report it the way they agreed to it. The time to identify personal goodwill is during negotiation, in writing, before anyone signs.

Whether goodwill is personal to the seller depends on whether it could have been transferred to the company. A physician whose patients would not have remained with the practice had the physician left earlier may hold personal goodwill. A veterinarian whose clients came to the clinic for the veterinarian rather than the location or the staff may hold personal goodwill. A contractor whose commercial clients hired the company because they knew the owner personally may hold personal goodwill. Whether that asset gets recognised depends on whether the purchase agreement describes it and allocates value to it.

The buyer's concern is that personal goodwill is not amortisable under Section 197. The buyer is purchasing something they cannot write off, so they generally want the allocation elsewhere. That is the negotiation. The seller's position is that personal goodwill is taxed once, at favorable rates. The buyer's position is that they are paying for an asset they cannot deduct. How that resolves depends on the total price, the composition of the business, and which side understands what is being negotiated.

How the residual method works

Section 1060 appears to require both buyer and seller to allocate the purchase price using the residual method, which assigns value to asset classes in a specified order. Our reading of the statute is that tangible assets are valued first, followed by identifiable intangibles other than goodwill, with goodwill and going concern value receiving whatever remains. The mechanics of that ordering are laid out in Treasury regulations, and the effect is that goodwill becomes the residual category after everything else has been valued.

The allocation is supposed to reflect the fair market value of each asset. A buyer and seller cannot simply agree to allocate the entire price to a category that suits one side's tax position if that allocation has no relationship to what each asset is worth. But within the range that appraisers would defend, the allocation is negotiable, and it is negotiated in every deal whether the seller realises it or not.

Both parties file Form 8594, Asset Acquisition Statement Under Section 1060, with their tax returns. The form requires the allocation across asset classes. If the buyer and seller report different allocations, both are exposed to an audit. In practice, the purchase agreement specifies the allocation and both sides report it consistently. Once signed, the agreement is binding on both parties, though not on the IRS if the allocation is found to be unreasonable.

What does the non-compete cost?

Most purchase agreements for a professional practice include a covenant not to compete. The seller agrees not to open a competing practice within a defined radius for a stated period. The buyer is paying to avoid having the seller reopen across the street. The covenant has value, and that value is part of the purchase price.

The allocation to the non-compete is where the tax difference is largest. To the seller, every dollar allocated to the covenant is ordinary income. To the buyer, it is a Section 197 intangible, amortisable over fifteen years. The negotiation is over how much of the total price the covenant is worth. The covenant has value, but that value depends on how likely the seller is to compete, how much damage that competition would cause, and how enforceable the covenant is under state law. If the seller is 68 years old and retiring to a different state, the covenant is worth less than if the seller is 52 and staying local. The allocation should reflect that.

Equipment gets expensed quickly

Tangible assets — equipment, furniture, computers, vehicles — are depreciated by the buyer under the normal rules, and in many cases can be expensed immediately under Section 179 or claimed as bonus depreciation. The seller's tax treatment depends on how the asset was depreciated. Equipment that was fully depreciated and is now sold produces ordinary income to the extent of the prior depreciation deductions, a recapture rule that prevents a seller from turning ordinary deductions into capital gains on the way out.

This is one category where the interests of buyer and seller are less opposed. Both sides generally want the tangible assets valued at what they are actually worth. The buyer wants the deduction and the seller's recapture is often manageable. The difficulty is when the tangible assets are minimal — a professional practice with old furniture and aging computers — and the buyer's attorney tries to allocate a large number to equipment that is not there. At that point the seller is being asked to report income on the sale of assets the business does not hold, which is an indefensible position if audited.

Enterprise goodwill vs personal goodwill

The distinction that matters is whether the goodwill would transfer with the business or leave with the owner. Enterprise goodwill is what the company built — its location, its phone number, its systems, its website, its referral relationships with other businesses, the reputation of the practice as an institution. Personal goodwill is what the owner built — the clients who came because they knew the owner, the referral sources who trusted the owner personally, the reputation that would follow the owner to a new venture.

Factors that may support personal goodwill include: the business has no value without the owner, clients are not bound by contract and can leave, the owner's name is the business name, the marketing has been personal rather than institutional, the owner has not taken steps to transfer relationships to employees or to the business entity, and there is no evidence the relationships would survive the owner's departure. The more of those facts that apply, the stronger the claim to personal goodwill.

A professional practice is often heavy in personal goodwill. A dental practice where the patients came to see that dentist, a law firm built on one partner's clients, a medical practice where the physician's reputation is the asset — these are situations where much of what is being sold is personal. The question is whether that characterisation makes it into the purchase agreement before it is signed.

Valuation is the leverage

The allocation has to be supportable, which means there is a role for a valuation professional before the agreement is signed. The appraiser can assign a fair market value to the tangible assets, to the non-compete, and to the components of goodwill, and that valuation provides the foundation for the allocation schedule. A buyer who wants to allocate $600,000 to a non-compete will find it more difficult if an appraiser has concluded the covenant is worth $150,000. A seller who claims $1.5 million in personal goodwill will need to explain why that number is defensible if the business has institutional systems and diversified referral sources.

The valuation also provides the record if the IRS questions the allocation later. Section 1060 allows the IRS to reallocate if the agreed allocation does not reflect fair market value. A contemporaneous appraisal that supports the allocation makes that challenge much less likely to succeed. The cost of the valuation is small relative to the tax at stake.

This negotiation happens once

The allocation is not something a seller can revisit after the deal closes. The purchase agreement governs. If the agreement allocates the entire price to enterprise goodwill and the corporation, that is how it will be taxed, regardless of whether a portion of it was in fact personal goodwill that could have been structured differently.

The moment to negotiate the allocation is when the letter of intent is being converted into a purchase agreement. The schedule that allocates the price across asset classes is part of that agreement. A seller who does not focus on that schedule until after signing has already lost the negotiation. The buyer's attorney drafted the allocation in the buyer's interest. The question is whether the seller's attorney pushes back or lets it through.

For a C corporation seller, the personal goodwill question is particularly significant. Enterprise goodwill sold by the corporation is taxed at 21 percent at the corporate level, then again when distributed to the shareholder. Personal goodwill sold by the shareholder is taxed once at a maximum 23.8 percent. The difference on a $1 million allocation is substantial. That difference exists only if the personal goodwill is identified and valued in the purchase agreement.

Bottom line

The purchase price is one number in the headline and several numbers in the tax return. The allocation across equipment, covenant not to compete, enterprise goodwill, and personal goodwill determines the tax, and the allocation is written into the purchase agreement as a schedule. The seller who understands the distinction between ordinary income and capital gain, and between enterprise goodwill and personal goodwill, has a negotiation to conduct before the agreement is signed. After that, the allocation is permanent.

This article describes how the purchase price allocation rules are structured under the Internal Revenue Code as it stood in January 2025. It is not advice about any particular transaction. A business owner preparing to sell a practice should have the proposed allocation reviewed by a CPA and a business attorney who can evaluate how the agreement would apply to that sale, those assets, and that owner's specific tax position.