Understanding Sale of Goodwill Tax Treatment for Business Transactions
Defining Goodwill
Goodwill is an intangible asset that represents the value of a business beyond its physical assets. It includes factors such as brand recognition, brand reputation, customer relationships, and workforce expertise, to name a few. Goodwill is a valuable asset that can substantially increase the value of a business far beyond the fair market value of its assets and liabilities.
Examples of Goodwill Assets
Intangible assets that can be classified as goodwill include proprietary information and processes, branding assets and recognition, and customer relationships. According to IFRS and US GAAP accounting standards, an asset must have an indefinite lifespan to be considered a goodwill asset.
What is Goodwill in a Business Sale?
When one business is acquiring another, an exchange of value occurs. Let’s examine the implications of transferring goodwill in a business sale and how that impacts taxes. Interestingly, one of the defining factors of goodwill is that it is intrinsic to the business- i.e. it cannot be bought or sold independently of buying or selling the business.
2 Types of Goodwill
There are generally two types of goodwill: enterprise goodwill and personal goodwill.
Enterprise Goodwill
Enterprise goodwill is an intangible asset owned by and associated with the operation of the business entity. This type of goodwill includes branding, exclusive customer base and contacts, supplier networks, and other valuable intangible assets that are integral to the business’s operations and success. This is typically the type of goodwill that will be transferred in a business sale. Enterprise goodwill is treated as a capital asset for tax purposes. The profits on the sale of goodwill are taxed as capital gains for the seller (usually 15-20%, a lower rate than regular income tax).
Personal Goodwill
Personal goodwill is an intangible asset owned by the individual seller and encompasses their personal reputation, talents, education, experience, and connections. This type of goodwill is relevant when the key individual’s reputation, expertise, skill, and knowledge give a business its intrinsic value. Furthermore, it is relevant in Acqui-Hire M&A deals when the acquiring company seeks to acquire a particular company for their personal skillset. Personal goodwill is treated as regular income for tax purposes and would be taxed at the regular income tax rate for the seller.
Pre-Acquisition Considerations for Transfers of Personal Goodwill
It is important to confirm that the shareholder did not enter into a noncompetition agreement with the corporation at any time before an asset sale transaction involving personal goodwill. A careful review of any existing employment agreements is necessary to ensure that the shareholder is not bound by a long-term employment agreement that prevents them from competing with the business. Such an a agreement would seriously impair the value of the personal goodwill and may render the transaction worthless for the acquiring company.
Taxation of Goodwill in a Business Sale
As we mentioned, Enterprise Goodwill is considered a capital asset and is therefore taxed for the seller as a long-term capital gain. Long-term capital gains are taxed at thresholds beginning at 15% and graduating to 20%. On the other hand, personal goodwill (if relevant to the transaction) is taxed as regular income at the identical income tax rate for the seller.
Ordinary Income vs. Capital Gain
Amounts allocated to goodwill are considered favorable for the seller because they are taxed at a lower rate than ordinary income, which reduces their total tax burden.
Tax Implications of Goodwill Sales
The tax implications of a goodwill asset sale are complex and should be evaluated by an experienced CPA, financial advisor, or M&A consultant. It is crucial to structure the business sale properly to strategically reduce your tax obligations as a result of the sale.
Valuation of Goodwill: Benefits of Getting an Expert Valuation
Goodwill is a complex intangible asset that encompasses several subcategories of assets. It is crucial to value goodwill as accurately as possible to facilitate a fair and effective business sale and clarify the seller’s tax obligations.
A common approach to valuing goodwill is the average profits method. The formula for this method is as follows:
Goodwill = Average Maintainable Profits x Multiplier
Although the results are based on historical data and adjusted to exclude odd and nonrecurring income, it is a highly simplistic method that fails to yield accurate results. Especially when dealing with high value business transactions, inaccuracies in how goodwill value is calculated can translate into hundreds of millions of dollars lost- both in an inaccurate sale price and imprecise tax obligations. Learn more about the shortcomings of using valuation multiples here.
Determining Fair Market Value of Goodwill
AVGI brings over 30 years of business and intangible asset valuation experience to every valuation assignment, and our empirical methods yield results with unparalleled precision. We generally employ multiple relevant valuation approaches and then weight them logically to reach the most accurate valuation of the asset, goodwill, or business interest at hand. You can read more about how we value businesses and intangible assets here.
Importance of Accurate Valuation of Intangible Assets & Goodwill
Accurate valuation of goodwill is crucial for both accurate business sale pricing and tax purposes. Precisely quantifying the value of goodwill can affect the final negotiated sale price as well as the amount of taxes owed. Inaccurate valuation can lead to an unfair sale, overpaying taxes, or underpaying taxes, potentially incurring tax penalties and fines. Play it safe with a precise goodwill valuation from qualified valuation experts who specialize in intangible asset valuation.
Selling a business can be complex and requires expert assistance. Goodwill taxation, in particular, is a critical aspect of the sale process and requires professional guidance. AVGI strongly recommends seeking the guidance of a tax professional in addition to obtaining a valuation for strategic tax planning assistance throughout the process.
Allocation Methods for Goodwill
The allocation of goodwill is determined by the purchase price allocation method. This method allocates the purchase price of a business to its various assets, including goodwill, and facilitates an easier breakdown of the costs.
Depreciation of Goodwill: Do You Depreciate Goodwill?
No. Unlike other intangible assets with finite useful lives that depreciate, goodwill has an infinite useful life and does not depreciate. It is instead tested annually for impairment. A 2014 FASB ruling allowed private companies to elect to amortize goodwill over 10 years rather than perform costly annual impairment tests. However, public companies are required to perform the tests annually.
Planning Considerations for Goodwill Taxation
Planning for the sale of goodwill is crucial to minimize tax liability. Certain strategic moves can improve tax obligations and treatment. Therefore, expert assistance is recommended to ensure accurate valuation and strategic tax planning.
Tips to Maximize Your Goodwill Asset Valuation
There are some steps you can take to nurture and grow goodwill value in anticipation of an upcoming sale. Working on these things now can substantially increase the goodwill value later.
- Maintaining accurate financial records
- Enhancing brand reputation
- Strengthening customer relationships
- Document intellectual property and patents
- Develop and document proprietary processes. Utilize internal SOPs.
- Secure long-term agreements and contracts as these yield high returns
- Nurture supplier network relationships
- Focus on market positioning and niching.
Record Keeping and Goodwill Taxation
Accurate record-keeping is crucial for goodwill taxation, as this helps them maintain a “paper trail” proving their goodwill value.
What Records Should Business Owners Keep for Tax Purposes Related to Goodwill?
Business owners should keep accurate financial records, including business acquisition and sale agreements, financial statements, and appraisal reports. These records are essential for tax purposes and can help ensure compliance with tax laws. On the flip side, keeping incomplete or inaccurate records can lead to tax preparation complications, inaccurately filed tax returns, penalties, and costly fines.
In Conclusion: Understanding Sale of Goodwill Tax Treatment
Goodwill is a complex aspect of business sales that requires expert assistance to quantify for both business transaction and tax purposes. Understanding goodwill tax treatment is particularly crucial for business owners who are considering selling their company. Accurate valuation and allocation of goodwill can significantly impact the amount of taxes owed.
AVGI specializes in valuing intangible assets, including goodwill. Reach out today for a consultation!
