312 / How is “goodwill” treated when a deceased partner’s interest is liquidated under a business purchase agreement?

Under a liquidation agreement, partners may elect to treat amounts paid for goodwill as either the purchase price for a capital asset or as ordinary income. For partners retiring or dying on or after January 5, 1993, or for payments made under a written contract that was binding as of January 4, 1993, an additional requirement applies to the election to treat goodwill as ordinary income. This treatment may be elected only if capital is not a material income-producing factor in a partnership and a retiring or deceased partner was a general partner.¹

Where an agreement provides that part of the purchase price is for goodwill, the amount allocable to goodwill also will be treated as having been paid for a deceased’s interest in partnership property. Regulations state that payment for goodwill, to be treated as a capital transaction, must be reasonable. However, the value placed on goodwill by partners in an arm’s length agreement, whether specific in amount or determined by formula, generally will be regarded as the correct value.²

If the material income-producing factor/general partner requirements mentioned above are met and the agreement makes no provision for goodwill, or stipulates that payment for goodwill is to be treated as income, the amount paid for goodwill is taxable as ordinary income to the estate or other recipient. If treated as ordinary income, it is deductible by the partnership.³

Election to treat payment for goodwill as a capital investment or ordinary income may be made either in the original articles of partnership or in a subsequent business purchase agreement.⁴ The IRS has ruled that determination as to whether a professional practice has saleable goodwill will be made on the basis of all the facts in a particular case and not on the basis of whether a business is dependent solely on the personal characteristics of the owner.⁵