The tax consequences of the sale of a business are complex, and strategizing to avoid one tax type may lead to unanticipated tax in another form. A recent decision of the Court of Appeals of Iowa illustrates this point. Clark v. Dep’t of Revenue, No. 23-1529 (Iowa Ct. App. Dec. 4, 2024).
The Facts: Two business partners, William Clark and Barry Bengston (the “Taxpayers”), started an insurance business in the 1970s. Each owned 50% of the business and worked as employees—engaging in administration, management, and sales-related activities. These activities resulted in the cultivation of goodwill, held by the Taxpayers as individuals.
In 2016, the Taxpayers sold their insurance business to an unrelated limited company (the “L.C.”) via an asset sale. Simultaneously, each individual Taxpayer sold their goodwill to the L.C. While neither Taxpayer had a non-compete agreement with their business prior to the sale, each signed a non-compete agreement with the L.C. and sold their goodwill to it in exchange for $525,000 each.
On their Iowa personal income tax returns for 2016, both Taxpayers sought to deduct the capital gain earned on the sale of their goodwill. The Iowa Department of Revenue (the “Department”) disallowed the deduction, finding that the sale of the goodwill was not deductible because it did not amount to the sale of a business. After losses before the Department and the district court, both Taxpayers appealed to the Court of Appeals of Iowa.
The Decision: In determining whether the Taxpayers’ sale of goodwill qualified for Iowa’s capital-gains deduction, the Court of Appeals found that the following four requirements must be met:
- The capital gain must be “from the sale of a business” as defined under Iowa law;
- The taxpayer must have sold “all or substantially all of the… service of the business” – with “service of the business” defined to include goodwill;
- The taxpayer must have held the business for at least 10 years at the time of the sale; and
- The taxpayer must have materially participated in the business for at least 10 years at the time of the sale.
Because the Taxpayers owned the goodwill personally, they contended that they met the aforementioned requirements because they engaged in “the separate ‘business’ of being” employees and “cultivated personal goodwill.” The court was unpersuaded—finding the Taxpayers failed to provide any rationale “as to how providing services as an employee qualifies as a business.”
Even applying Iowa’s broad definition of a business, which includes any activity engaged in by any person “with the object of gain, benefit, or advantage[,]” the court found nothing in the record to support the Taxpayers’ argument that the actions that created the goodwill were done as part of a business separate from the Taxpayers’ insurance business. As the Taxpayers were unable to provide any evidence to support that they engaged in separate businesses as employees, the court determined that the sale at issue did not amount to the sale of the “service of the business,” making the capital gain deduction unavailable to the Taxpayers.[1]
Despite its holding, the court and the Department both acknowledged that the outcome of the case would likely have been different if the Taxpayers had first sold their goodwill to their insurance business in exchange for a non-compete agreement. If such a sale had taken place, the personal goodwill would have been transformed “into an asset of the business of being an employee.” Capital gain from the subsequent sale of the goodwill would then be deductible assuming the other enumerated requirements were met.
The Takeaway: The structure of the Taxpayers’ sale of their insurance business as the separate sale of the assets and their personal goodwill is a common one—desirable from a federal tax perspective because the sale of the personal goodwill should qualify for long-term capital gain treatment. However, the Department’s deduction denial certainly resulted in unanticipated state tax from the sale. While both the court and the Department acknowledged that the sale could have been structured differently to avoid the Iowa tax, such a structure may have cost the Taxpayer’s their federal capital gains treatment.
Though sometimes taxation is inevitable, and a goal may be tax minimization, it is imperative that taxpayers plan for the federal and state tax consequences of the sale of their business prior to the sale taking place.
[1] Perhaps the evidence the Taxpayers needed was in the transcript of the hearing before the administrative law judge – which the court noted was not provided to it nor to the district court.
This update is one in a series of updates written for the January 2025 edition of The BR State + Local Tax Spotlight.
© 2025 Blank Rome LLP. All rights reserved. Please contact Blank Rome for permission to reprint. Notice: The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.
