How is Goodwill Taxed When Selling a Business?
Aside from the mountains of legal paperwork you will need to complete when selling your business, there are other critical accounting issues you can't avoid.
These issues include business valuation, determining goodwill, and paying taxes on that goodwill, which is the focus of this article.
What Is Goodwill?
Goodwill is the excess amount an acquirer of a business (buyer) pays over and above the fair market value of the target company’s (seller) net assets.
Several factors can generate goodwill, including customer relationships, brand name recognition, business reputation, and personal relationships.
Take business reputation, for instance. It’s not a tangible asset, yet it can make up a significant part of a business’s value.
How to Calculate Goodwill
To calculate goodwill, the buyer takes the purchase price and subtracts the fair value of the seller’s net assets.
Net assets = assets minus liabilities.
Goodwill, written as a math equation, is
Goodwill = P - (A - L)
where
- “P” represents the purchase price,
- “A” is the business assets, and
- “L” is the company’s liabilities
Remember that the value of assets and liabilities in calculating goodwill is their fair value, not their book value.
Book value, also known as carrying value, is the value of corporate assets and liabilities as reflected on the company’s balance sheet. Book value often differs from fair value because it’s the historical value.
Fair value, on the other hand, is how much the asset or liability would sell for in the open market.
So let’s assume that at the time of sale, your target’s assets would sell for $200,000 and liabilities settled for $80,000.
How much is the goodwill if you’ve agreed on a purchase price of $300,000?
Based on the equation above, the goodwill is $180,000 = $300,000 (P) - ⦗$200,000 (A) - $80,000 (L)⦘.
How Is Goodwill Taxed in the Sale of a Business?
For starters, a sale transaction can either be an asset sale or a stock sale. In our scenario, we’ll assume the transaction is an asset sale.
The IRS requires that in a sale of a business, the buyer and seller mutually agree (through a purchase agreement) on the fair value of seven individual asset classes.
These asset classes include:
- Cash
- Certificates of deposits and investments
- Account receivable
- Inventory
- Fixed assets (such as furniture and equipment)
- Copyrights, non-competes, and other intangible assets other than goodwill
- Goodwill
Generally, the amount allocated to goodwill is the residual amount, or the amount remaining after you have agreed on the fair value in the other six categories.
In most cases, when a seller has goodwill, it’s taxed at long-term capital gains rates. But if the seller owned the business for less than a year, the goodwill could be taxed at ordinary income tax rates.
Let’s look at an example.
Assume you sold your business for $600,000 and that, in agreement with the buyer, you allocated $200,000 to furniture and $150,000 to inventory. And there were no other assets or liabilities.
Your goodwill (the residual amount after the allocations) will be $250,000 ($600,000 - [$200,000 + $150,000]).
|
2023 Long-term Capital Gains Tax Rates, Single Filers |
|
|
Long-term capital gain amount |
Tax rate |
|
$0 - $41,675 |
0% |
|
$41,676 - $459,750 |
15% |
|
More than $459,750 |
20% |
Your goodwill of $250,000 falls in the 15% tax rate, so the tax on your goodwill will be $37,500.
Taxation for selling a business is one of the most complicated areas of tax law. Please consult with a qualified tax professional when you’re considering selling your company.
Goodwill Concerns for Business Buyers
Because of tax considerations, buyers generally prefer higher purchase price allocations to capital assets, such as vehicles, and lower purchase price allocations to goodwill. This is because goodwill gets amortized over a longer period (15 years), and the annual tax-deductible amount can be tiny. On the flip side, vehicles generally depreciate over a shorter period (5 years), creating higher annual tax savings.
Do All Businesses Have Goodwill?
No. Generally, only a company, including a small business, whose purchase price exceeds the fair value of its net assets, will have goodwill.
Types of Goodwill
The IRS generally recognizes two types of goodwill with different tax implications: business goodwill and personal goodwill.
Personal goodwill is attributed to an individual’s own efforts, character, or reputation. For instance, suppose customer loyalty is due to the professional reputation of a partner or shareholder and can’t be transferred to the new owner.
The goodwill recognized in the sale of a business will be transferred to the individual partner or shareholder. Consequently, it is the partner or shareholder who will pay the income tax on the goodwill and not the business.
When assembling a team of experts to assist in selling a business, be sure to include a CPA. Taxes are an important consideration when you sell your company, and every small business has unique conditions to evaluate. Your accountant, along with a business broker and attorney, will be able to guide you through the process to ensure a successful sale.