And the Grounds for Treating His Compensation as Compensation
Judge Holmes (The Great Dissenter, a/k/a The Judge Who Writes Like a Human Being), again exhibiting his disdain for the partitive genitive (c’mon Judge, a “couple thousand people?”, 2012 T. C. Memo. 290, at p. 2), tells the tale of Harold Schmeets, a prominent citizen of Harvey, North Dakota. H & M, Inc., is the case, 2012 T. C. Memo. 290, filed 10/15/12.
Harvey is a tiny town where fewer people move in than die or move out. But Harold moved in forty years ago and stayed. He was a go-getter, known far and wide across prairie and badlands to the outermost little house on the prairie as The King of Insurance, even to his competitors, none of whom, it is admitted, can hold a ten-year level-premium term life policy to Harold. He started selling insurance for the local bank, but bought out their insurance operation (a C corporation, of course) over the years. He was the acknowledged expert on bonding: getting payment, performance and completion bonds for contractors; and sweet-talking the big insurers into writing policies in this miniscule crossroads hamlet.
Finally, the bank buys out Harold, who wants to secure his old age and the educations of the kiddies he and Miz Mona bestowed on Harvey, ND, to counterbalance the movers and diers.
Harold does the deal without an attorney and asks the bank’s accountant to look it over. Basically, the price for the name and goodwill of the agency is peanuts, and everything in an employment agreement with Harold.
IRS claims the deal is really a disguised capital gain at corporate rates and dividends to Harold. No, says Judge Holmes: “The bank’s insurance agency dropped its name in favor of Harvey Insurance Agency, Inc. because Harvey Insurance had been around longer and had more name recognition because of its association with Schmeets. Schmeets served as its manager for the entire six-year term of the employment agreement, and the bank reported his compensation as wages subject to withholding and Federal Insurance Contributions Act (FICA) tax. Schmeets rewrote existing insurance policies, took new applications, supervised and trained the agency’s four employees, attended bank planning sessions, negotiated commissions with insurance companies, and did the agency’s bookkeeping. The transition multiplied his responsibilities, and Schmeets went from a 40-hour work week before the sale to almost double that after.
“At the end of the six-year term, the bank was pleased with Schmeets’s performance and asked him to continue to manage the agency under year-to-year contracts. Schmeets agreed and kept working several days a week for about $30,000 per year to help train his replacement. The replacement was an insurance salesman that didn’t have as much experience as Schmeets–he didn’t do bonding work, and he had never been a manager. Despite this lack of experience, the bank paid the new man an annual salary of between $55,000 and $65,000. Having managed this last transition, Schmeets then retired.” 2012 T. C. Memo. 290, at pp. 9-10.
IRS claims form-over-substance: the bank bought the agency. Harold says no: the bank bought Harold.
Judge Holmes: “There will be no salable goodwill, however, where the business of a corporation depends on the personal relationships of a key individual, see Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, 207-08 (1998), unless he transfers his goodwill to the corporation by entering into a covenant not to compete or other agreement so that his relationships become property of the corporation, see Norwalk v. Commissioner, T.C. Memo. 1998-279, 1998 WL 430084, at *7.” 2012 T. C. Memo. 290, at pp. 19-20.
Moreover: “The insurance business in Harvey is ‘extremely personal,’ and the development of Harvey Insurance’s business before the sale was due to Schmeets’s ability to form relationships with customers and keep big insurance companies interested in a small insurance market. He grew relationships with large insurance companies that other brokers in the area didn’t. And we specifically find that when customers came to his agency, they came to buy from him–it was his name and his reputation that brought them there. We also find he had no agreement with H & M at the time of its sale that prevented him from taking his relationships, reputation, and skill elsewhere, which was precisely what he did when he began working for the bank’s renamed insurance agency.
“Beyond the business’s goodwill, the Commissioner doesn’t specify what other purchased intangible assets, other than the name Harvey Insurance, he thinks were not accounted for in the purchase price. We have already found that the name Harold Schmeets had by far more name recognition in the community than Harvey Insurance. And the Commissioner hasn’t given us any persuasive evidence that the name of the corporation had much value other than its connection with Harold Schmeets himself.” 2012 T. C. Memo. 290, at pp. 21-22 (Footnote and citations omitted).
Harold’s personal taxes are not before the Court, so the question of adequacy of Harold’s compensation really isn’t an issue, although Harold’s replacement, a mere Baron or Earl of Insurance, says Judge Holmes, is paid twice what Harold was paid.
Harold runs into some of what they call “bob wahr” when it comes to a note from his wholly-owned corporation, and some unsubstantiated deductions, but they’re small compared to his employment as King of Insurance in the fair town of Harvey.
Takeaway- Goodwill counts for little if your name is your fame.