Tax Planning for a Business Sale: Factoring in Goodwill

The term “goodwill” might initially bring to mind donating items to charity or even Christmas carols. However, in the world of tax accounting, goodwill refers to intangible assets that increase a company’s value. This can include things like the company’s brand name, strong customer base, positive customer or employee relations, and proprietary technology. The goodwill value is typically equal to the difference between the purchase price of the company and the sum of the actual assets and liabilities acquired.

Tax planners will find that a common obstacle to structuring the sale of a business is the competing interests of the buyer and the seller. From a tax standpoint, what is advantageous for the buyer is often disadvantageous to the seller and vice versa.

When it comes to goodwill, this portion of the business value will be treated as capital gain for the seller, rather than ordinary income. Since capital gains are taxed at a lower rate than income, a higher percentage of goodwill is more beneficial to the seller.

The buyer, however, experiences more goodwill as a disadvantage. This is because the buyer cannot take a deduction for that amount but rather will have to gradually write off the cost over time. In a business sale, deciding on the goodwill value can be a friction point between buyer and seller.

One key tax strategy that is beneficial to sellers and typically has no impact on buyers is illustrated in the famous “Martin Ice Cream Company” court case of 1998. The strategy involves separating the goodwill value of the company from the “personal goodwill” that comes from the reputation, expertise, and relationships of the owner or executives of that company. According to this court case decision, as long as a corporation has no employment contract with an employee (which can be true in the case of an owner), that employee’s personal relationships are not considered company assets.

What this means is that a seller could theoretically create two separate business deals—one that is between the selling company and the buying company and one between the owner and the buying company. By selling the personal goodwill separately, the seller will see lower taxation since the proceeds can be treated as long-term capital gains, which can also be offset by capital losses. In the case of C corporations, this can help reduce double taxation.

Despite the clear benefits of this strategy, tax planners should note that not all clients may be eligible. There are dissenting court cases where the taxpayer was ruled against when conflicting information was presented. For instance, if the owner or executive has a covenant not to compete with the company, the IRS can push back. The non-compete implies that the company owns the goodwill, and therefore, the owner would not be permitted to sell the goodwill separately from the company as a whole. If possible, the seller would need to terminate the non-compete before conducting the sale.

Business sale negotiations can easily get stalled when the parties involved are not aware of the tax strategies available in their situation. Both buyers and sellers need the help of an expert to identify ways to secure tax benefits without disrupting the business deal. To receive in-depth training to better serve these clients, contact us about becoming a Certified Tax Planner.

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