As the end of the year approaches, many businesses seek to eliminate Texas franchise tax and corporate income tax by declaring and paying large bonuses to shareholder employees in an attempt to zero-out the taxable income of the corporation.

However, any year-end bonus paid to the shareholder-employees is subject to payroll taxes, half of which are imposed on the employer and half of which are paid by the employee. The social security portion of the FICA tax is imposed at a rate of 12.4% of the first $84,900 of compensation in 2002. The Medicare portion of the tax is imposed at a rate of 2.9%, with no limit on the amount of compensation subject to the Medicare portion. Thus, in order to avoid the 4.5% Texas franchise tax, the shareholder-employees are incurring a 2.9% Medicare tax.

There is a potential solution to this problem. Two relatively recent Tax Court cases have recognized the concept of “personal goodwill.” In Norwalk v. Commissioner, TC Memo 1998-279, an accounting firm organized as a corporation liquidated and two of the shareholder-employees joined another accounting firm. The IRS argued that the shareholder-employees recognized income from a distribution of goodwill to the shareholder-employees upon the liquidation of the corporation. The Tax Court found that since there was no covenant not to compete between the corporation and the shareholder-employees, that any clients would likely follow the individual accountants. Therefore, the goodwill associated with these relationships was the property of the shareholder-employees and not the corporation.

In Martin Ice Cream Company v. Commissioner, 110 T.C. 189 (1998), the taxpayer was a corporation engaged in the distribution of ice cream products, including Haagen-Dazs products. The corporation engaged in an internal reorganization which culminated in a newly formed subsidiary and the sole shareholder of the newly formed subsidiary selling the Haagen-Dazs distribution rights. The IRS argued that the sole shareholder recognized income upon the deemed liquidation of the corporation equal to the amount that the purchaser of the Haagen-Dazs distribution rights paid to the sole shareholder for the covenant not to compete. The Tax Court found that the personal relationships and distribution network developed by the sole shareholder were his separate property and not corporate assets.

Both Norwalk and Martin Ice Cream acknowledge the concept of personal goodwill. Thus, it may be possible for a corporation to make ongoing payments to shareholders for personal goodwill which the shareholder-employee allows his or her corporation to use. Payments received by the shareholder employee would not be considered compensation and, therefore, would not be subject to the 2.9% Medicare tax.

Another reason to consider the concept of “personal goodwill” is that a recent Tax Court case involving Fort Worth pediatricians has placed some doubt in the ability of a corporation to zero out its taxable income by paying bonuses to shareholder-employees. In Pediatric Surgical Associates P.C. v. Commissioner, TC Memo 2001-81, the taxpayer corporation paid bonuses to its shareholder- employees in an attempt to zero out the corporation’s taxable income. The Tax Court limited the compensation deduction to that portion of the bonuses which was attributable to the shareholder employees’ own services. Since Pediatric Surgical employed non-shareholder-employees, the corporation could not deduct as compensation to the shareholder-employees profit generated by the non-shareholder-employees.

This case is potentially troubling for personal service firms which engage in year-end tax planning by paying large bonuses, particularly when the firm has non-shareholder-employees which provide professional services.

The Blum Firm can assist you in drafting a licensing agreement and Board minutes whereby the shareholder-employees license their personal goodwill to the corporation in exchange for a royalty payment which will not be subject to the 2.9% Medicare tax. By establishing a history of payments to shareholder-employees for the use of personal goodwill under the terms of a license agreement, it should be possible to reduce both Texas franchise tax and corporate income tax upon the sale of a business since any purchase price allocated to a covenant not to compete can be paid directly to the shareholder-employee.

Additionally, we have found that most businesses are not structured to minimize payroll taxes as well as the Texas franchise tax. We are developing techniques to assist clients in restructuring their businesses in a tax efficient manner in order to lessen or eliminate the future impact of these taxes.

If you are interested in discussing how these concepts may benefit you, please call Mary at (817) 334-0066 and she will direct you to an attorney who can discuss these concepts with you.

For over twenty years, The Blum Firm, P.C. has been a leader in the areas of estate planning, tax, probate, asset protection planning, planning for closely-held businesses, and tax-exempt organizations. The Texas Board of Legal Specialization has certified four of the attorneys (three in Estate Planning and Probate Law, and one in Tax Law) and four are Certified Public Accountants.

The firm stays on the cutting-edge of new developments and takes a proactive view of tax planning. As a specialty firm, it provides the ideal environment to serve the tax and estate planning needs of families, professionals, and businesses. In addition to its traditional lines of practice, the firm’s newest focus is to work with businesses to eliminate franchise tax, minimize income tax, protect the business and owners from liability exposure, and plan for business succession at death or retirement. In the current environment, individuals (especially medical professionals and small business owners) are seeking the firm’s services more and more for asset protection.

Marvin Blum, J.D., C.P.A., received his J.D. from the University of Texas School of Law graduating second in his class. He received his B.B.A. in Accounting from the University of Texas at Austin graduating as valedictorian. Mr. Blum is board certified in Estate Planning and Probate Law.

Gary V. Post, J.D., received his J.D. from Southern Methodist University School of Law and his B.B.A. magna cum laude from Texas A&M University. He is board certified in Estate Planning and Probate Law.

John R. Hunter, J.D., C.P.A., received his J.D. cum laude from the University of Houston Law Center and his Master of Accounting and B.A. (cum laude) from Rice University. Mr. Hunter is certified by the Texas Board of Legal Specialization in Tax Law.

Catherine R. Moon, J.D., C.P.A., received her J.D. with honors from the University of Texas School of Law and her B.B.A. with high honors from the University of Notre Dame. Ms. Moon is board certified in Estate Planning and Probate Law.

Lorri H. Kendrick, J.D. received her J.D. from the University of Texas School of Law and her B.A. summa cum laude from Abilene Christian University.

Daniel H. McCarthy, J.D., C.P.A., received his J.D. from DePaul University and his B.S. in Accounting from the University of Illinois.