Selling or Passing On a Consulting Firm: Partner Buyouts, Personal Goodwill, and Why the Firm May Be Worth Less Than the Partners

Consulting firms are hard to sell because the asset walks out the door at five, and the tax planning starts from that fact. What a consultancy is worth, and to whom: a buyer pays for the firm's recurring revenue (retainers and repeat clients), its bench (the W-2 consultants — the classification guide — who stay), its methodology and tools (the intellectual property the firm owns — the deductible investment behind them), its brand, and — the largest and most fragile component — the client relationships, which in a founder-led firm belong to the founder personally more than to the entity; the valuation (a multiple of revenue or of adjusted earnings, discounted for the relationships' transferability) is lower than a product business's at the same revenue, and the earn-out (payments contingent on client retention over two or three years) is how buyers bridge the gap. The exit routes. Internal succession — a partner or partners buy the founder out: the cleanest route for a firm with a bench that includes future owners, structured as a purchase of the founder's interest over time (a note, or installment payments from the firm's cash flow), with the founder's transition of client relationships as the operational core and the tax structure depending on the entity. Sale to a strategic buyer (a larger firm acquiring capability or a client base) or a financial buyer (private equity rolling up consultancies — an active market): an asset sale or an interest sale, with an earn-out, the founder's employment or consulting agreement for the transition period, and a non-compete. Wind-down: a founder who transitions clients to other firms for referral fees or simply closes — the least valuable route, and the default for a firm that never planned. The tax structures. Pass-through firms (LLCs, partnerships, S corporations — most consultancies): an asset sale (the buyer purchases the firm's assets — client contracts, the methodology, the brand, the goodwill — and the firm distributes the proceeds) is taxed once — the gain flows to the owners at capital gain rates for the goodwill and other capital assets (with ordinary income for any depreciation recapture on equipment and for the portion allocated to a non-compete), and the buyer gets a stepped-up basis to amortize (the goodwill and intangibles over fifteen years under section 197 — the franchise fee guide's mechanics apply to a buyer's purchased goodwill); an interest sale (the buyer purchases the owners' LLC units or S corporation shares) is also a single tax at capital gain rates for the sellers, with the buyer inheriting the entity's basis (no step-up unless the parties make the election that treats a qualifying stock purchase as an asset purchase — available for S corporation stock sales, and a negotiated point because it shifts value between buyer and seller) — buyers of pass-throughs generally want the asset purchase or the step-up election, and sellers accept it because the tax is the same for them. C corporation firms — the double-tax problem: a C corporation's asset sale is taxed at the corporate level (the corporation's gain on the assets) and again when the proceeds are distributed to the shareholders (a dividend or liquidating distribution) — two taxes on the same value; a stock sale avoids the corporate tax (the shareholders sell their shares at capital gain rates) but buyers resist it (no step-up, inherited liabilities) — and the resolution for a founder-led consultancy is personal goodwill. Personal goodwill — the founder's own asset: where a firm's value depends on the founder's personal relationships, reputation, and skills — and the founder has no employment agreement or non-compete with the firm that would have transferred those relationships to it — the goodwill attaches to the founder personally rather than to the corporation, and the founder can sell it directly to the buyer in a separate transaction (a personal goodwill purchase agreement alongside the corporation's asset sale), taxed once as the founder's capital gain and outside the corporation entirely; the doctrine (established in the case law and applied where the facts support it) requires that the goodwill genuinely be personal — the founder's relationships, not contracts owned by the firm; the founder's freedom from a pre-existing non-compete with the firm (a founder who signed one has already transferred the goodwill to the corporation); a real allocation supported by a valuation; and a non-compete from the founder to the buyer as part of the personal goodwill sale (the buyer is paying for the relationships and needs the founder not to take them elsewhere) — the structure that turns a C corporation consultancy's double tax into a single one on the largest component of value, and one that requires the founder to have avoided the corporate non-compete years earlier; a pass-through firm has no double tax to avoid, but the personal goodwill analysis still matters for the allocation between the entity's assets and the founder's, and for the non-compete's treatment. The non-compete: payments allocated to the founder's covenant not to compete are ordinary income to the founder (not capital gain) and amortized over fifteen years by the buyer — so the allocation between goodwill (capital gain to the seller) and the non-compete (ordinary to the seller, same amortization to the buyer) is negotiated, with the buyer indifferent and the seller wanting the goodwill allocation supported by the valuation. The earn-out: contingent payments tied to client retention or revenue targets — taxed to the seller as received (the installment method applies to the contingent-payment sale, with the basis recovery rules for contingent consideration — a computation the sale's tax advisor runs), with the character following the underlying asset (capital gain for goodwill), and with the risk that an earn-out structured as compensation for the founder's transition services (the founder's post-sale employment or consulting agreement) is ordinary income — the agreements separate the purchase price (capital) from the transition compensation (ordinary) explicitly. Partner buyouts inside a partnership: a departing partner's payments are governed by the partnership rules — payments for the partner's share of partnership property (capital gain, with the hot-asset rules converting the share of unrealized receivables — a cash-method consultancy's unbilled and uncollected work is an unrealized receivable — and inventory to ordinary income), and payments treated as guaranteed payments or distributive shares (ordinary to the partner, deductible to the partnership — the section 736(a) payments for a general partner's share of goodwill where the partnership agreement doesn't provide for goodwill payments, and for unrealized receivables in a service partnership); the partnership agreement's drafting decides the character of the departing partner's payments, and a consultancy's agreement is drafted with the retirement payments' tax treatment in view (the section 736 elections and the agreement's goodwill provision). The S corporation partner buyout: a redemption of the departing shareholder's stock (capital gain to the shareholder, with the corporation's redemption payments non-deductible) or a cross-purchase by the remaining shareholders (capital gain to the seller, basis to the buyers) — with the corporation's accumulated adjustments account and the shareholders' basis tracked, and with the single-class-of-stock rule constraining any payment structure that looks like a preferred return. The transition: the founder's post-sale role (employment or consulting agreement — ordinary income, and the buyer's deduction), the client introductions and the relationship transfer (the operational work the earn-out measures), and the bench's retention (the buyer's retention bonuses, and the classification and plan issues the bench brings — the classification and retirement guides). The planning that starts years before: avoid a corporate non-compete if personal goodwill will matter (or structure the founder's agreement to preserve it); build the bench and the methodology the firm owns (the transferable value); convert a C corporation to an S corporation well ahead of a sale (the built-in gains tax on appreciated assets applies for the five-year recognition period after conversion — so the conversion is timed years out); document the client relationships' ownership; and draft the partnership or shareholder agreement's buyout provisions with the tax character in view.

Key takeaways

• A consultancy's value is mostly relationships and people — priced lower than a product business at the same revenue, bridged by earn-outs, and transferable only through the founder's transition work.
• Pass-through firms are taxed once on a sale (asset or interest), with buyers wanting the asset step-up (or the election that provides it) and sellers indifferent; C corporations face double tax on an asset sale — and personal goodwill is the escape.
• Personal goodwill — the founder's own relationships and reputation, sold directly to the buyer as capital gain outside the corporation — requires that the founder never signed a non-compete with the firm, a real valuation, and a non-compete to the buyer.
• The non-compete allocation is ordinary income to the seller; the earn-out is taxed as received with the underlying asset's character — and transition compensation must be separated from purchase price or it's ordinary.
• Partner buyouts follow section 736 and the hot-asset rules (a cash-method firm's unbilled work is an unrealized receivable) — the partnership agreement's drafting decides the departing partner's character.
• Plan years ahead: no corporate non-compete for the founder, a bench and methodology the firm owns, an S conversion timed outside the built-in gains period, and buyout provisions drafted for their tax character.

The consultancy's exit file

Entity and its history (C to S conversion date; built-in gains period). Founder's agreements with the firm (any non-compete — the personal goodwill question). Client relationships: who owns them (contracts with the firm, or the founder's). Bench: W-2 status; retention; plan. Methodology and IP: owned by the firm. Valuation: entity goodwill vs personal goodwill; non-compete allocation. Partnership or shareholder agreement: buyout provisions and section 736 treatment. Earn-out and transition compensation separated. The non-compete line is the one decided years before the sale — and the one that decides whether a C corporation's founder pays once or twice.

Worked example

Two founders sell consultancies. Founder one: a C corporation strategy firm, US$6 million of revenue, founder-led relationships, no non-compete between the founder and the corporation (his advisor flagged it a decade earlier). The deal: US$9 million total — the buyer purchases the corporation's assets (methodology, brand, contracts, bench) for US$4 million and, in a separate agreement supported by a valuation, purchases the founder's personal goodwill for US$4.5 million with a five-year non-compete to the buyer; US$500,000 is allocated to the corporate non-compete and the founder's transition consulting agreement (ordinary). Tax: the corporation's US$4 million asset gain is taxed at the corporate level and again on distribution (the double tax on the entity's assets — accepted because the entity's assets are the smaller component); the founder's US$4.5 million personal goodwill is a single capital gain outside the corporation — the structure saves him a corporate-level tax on the largest piece; the earn-out (US$1.5 million of the total, contingent on client retention) is taxed as received with the goodwill's character, separated in the agreements from his transition consulting fees. Founder two: an S corporation with three partners, a bench of nine, and a founder retiring while the other two partners continue. The buyout: a redemption of the founder's stock over five years at a valuation of the firm's goodwill (the firm owns the methodology and the client contracts, and the founder had a non-compete with the firm — the goodwill is the firm's, which is fine in a pass-through with no double tax), capital gain to the founder, the redemption payments non-deductible to the corporation, the accumulated adjustments account and the remaining partners' basis tracked; the founder's two-year transition role paid as W-2 compensation, separated from the redemption price. The cautionary tale is the C corporation founder down the street who signed a corporate non-compete at formation on a lawyer's template — the goodwill is the corporation's, the asset sale is double-taxed on all of it, and the stock sale the buyer won't accept is his only single-tax route.

Official sources

The IRS states that "you must generally amortize over 15 years the capitalized costs of 'section 197 intangibles'" — which include franchises, trademarks, and trade names — while contingent serial payments for a franchise, such as royalties based on productivity or use, are deductible as paid rather than capitalized. — Internal Revenue Service, Intangibles, https://www.irs.gov/businesses/small-businesses-self-employed/intangibles

The IRS states that "S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes." Shareholder-employees who perform services must be paid reasonable compensation as wages before distributions, and the election is made on Form 2553. — Internal Revenue Service, S corporations, https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

Practitioner note

A consulting firm's value walks out the door at five, and the tax planning for its sale starts a decade earlier with one document: the founder's non-compete with the firm, which either transfers the personal goodwill to the corporation or leaves it the founder's to sell once at capital gain rates. Our exit files sort entity goodwill from personal goodwill with a valuation, separate the earn-out from the transition compensation, and draft partnership buyout provisions for their section 736 character — because a C corporation founder who signed the template non-compete at formation pays twice on the piece that was worth the most.

See also: For related guidance, see the consulting firm's entity structure and the QBI cap; and browse every small business tax guide, by situation.

Next step

Fairlight Accounting is a cross-border accounting and tax practice with a U.S. Tax Desk and a Canadian Tax Desk. Our U.S. Tax Desk handles consulting firm exit and succession planning — entity and personal goodwill analysis, asset versus interest sale structuring with the step-up election, non-compete and earn-out allocation, C-to-S conversion timing, and partner buyout provisions under the partnership and S corporation rules. See pricing or book a call.