Here's How Goodwill is Taxed When Selling a Business (EXPLAINED)
“How is goodwill taxed when selling a business?” This is a common question for any entrepreneur thinking about their exit strategy.
For many business owners, selling away their life's work still means a pretty big deal financially. However, negotiating the tax implications of deals that huge can be difficult, especially when it’s about a specific intangible asset—goodwill.
Worry not; our comprehensive guide digs into the taxation of goodwill when selling a firm, providing an easy-to-follow roadmap to help entrepreneurs make informed decisions.
Continue reading to learn about the definition of goodwill, its significance in business valuation, and the specific tax regulations that govern its treatment upon sale.
TL;DR - What Happens to Goodwill When You Sell a Business?
Goodwill is your company's intangible value beyond its physical assets.
When you sell goodwill, the buyer pays handsomely for it.
There's a catch, though—the seller must pay taxes on the profits.
The good news is that it is typically taxed as a capital gain, which is lower than standard income tax.
The bad news is that it is difficult to value using methods such as Average Profits, Installment Sales, etc.
Furthermore, maintaining records at all times is required.
Need help? Speak with Exitwise's professionals and M&A experts, who can walk you through the process and maximize your exit value.
What is Goodwill in a Business Sale?
Goodwill, an intangible asset, goes beyond the selling organization's list of identifiable assets and liabilities. Its monetary value usually appears in the acquisition price. This extra charge represents the intangible assets (workforce, customer loyalty, brand reputation, etc.) that guarantee further long-term success and revenue.
What Type of Property is Goodwill?
Goodwill is listed as an intangible asset, unlike tangible ones like land, infrastructure, cash/stocks, furniture, etc.
Here’s the thing: goodwill significantly raises or lowers the company’s future earning potential despite lacking a physical form, thereby making it valuable.
Is Goodwill a Capital Asset?
Yes, goodwill is categorized as a capital asset (for tax reasons).
You'll notice it contrasts with inventory and accounts receivable (current assets). Essentially, this difference exists because goodwill sales generate capital gains.
In the next section, we’ll discuss how this makes a difference.
Why is Goodwill Taxed When Selling a Business?
The whole concept of tax on goodwill may seem counterintuitive at first. That said, here’s why goodwill (despite being an intangible asset) falls under the tax umbrella:
Recognizing the True Value of Goodwill
Goodwill encompasses immeasurable assets like existing customer relationships, brand awareness, and a trained workforce, all contributing to future earnings. Here’s how:
Repeating business from a long-lasting client base directly correlates with strong customer loyalty and a great brand reputation.
An experienced workforce, coupled with pre-existing vendor/customer relationships, boosts operational efficiency and market access.
Proprietary expertise, intellectual property, and distinct procedures give the company a competitive advantage in the market.
Access to a prime location (physical/online) further helps draw more clients and spur further expansion.
Because the buyer acknowledges and pays for this future worth, taxation of goodwill assures tax equity.
Here’s what you should keep in mind:
Goodwill, like brand recognition, is intangible and difficult to quantify. Tax authorities seek to tax this value transfer fairly, but it’s not always easy to measure accurately.
Don’t fall behind. Contact Exitwise today to schedule a quick consultation and learn how we can help you hire the experts to complete a successful and tax-efficient business sale.
How to Value Goodwill When Selling a Business
Goodwill should always be valued accurately for the business sale to be effective and fair. Fortunately, the average profits method can often be a great place to start.
What is the Average Profit Method?
The AP method uses readily available historical data for goodwill valuation. This data-driven method estimates goodwill by multiplying average maintainable earnings by a fixed multiplier. Here's the core formula:
Goodwill = Average Maintainable Profits x Multiplier
Remember: average maintainable profits should not be limited to the most recent fiscal year. Weigh in trends; exclude non-recurring expenses and odd income.
Multiplier, another key factor in determining the final goodwill value, reflects the business's future growth potential, core market, and risk profile. Industry standards, comparable sales figures, and expert judgment are your best friends when determining the right multiplier.
However, the Average Profits approach comes with a set of limitations as well. Such as:
This strategy tends to be retroactive, failing to address future growth prospects or industry trends.
Using this method, a stagnating business with constant profitability can appear equally valuable as a prospering firm with excellent prospects.
The selected capitalization rate significantly impacts the final value.
Choosing an incorrect rate can drastically over—or undervalue the goodwill.
Alternative Methods to Average Profits
Looking to try a different method? Here are some popular approaches you can choose to value goodwill:
Comparable Company Analysis
This method compares the company to similar ones previously sold. It can estimate how much your business is worth by examining the sale prices and accounting for any relevant differences.
Discounted Cash Flow
This method estimates future cash flows and then discounts them to present value. It offers a more in-depth review but requires accurate forecasting and financial skills. Despite being more complex, it considers industry trends and future growth possibilities.
Overview of Capital Gains Tax on Sale of Business Goodwill
Capital gains stem from selling capital assets like stocks, bonds, or real estate. These profits are often taxed less than ordinary income, which includes salaries, wages, and interest income.
Because it is the value linked with future earnings—rather than a physical asset—goodwill is classified as a capital asset.
Is the Sale of Goodwill a Capital Gain?
Yes, in most jurisdictions (including the United States), the sale of goodwill is normally regarded as capital gains, taxed differently than ordinary income.
Ordinary income is subject to the regular income tax rate, which can reach 37% in the USA. Long-term capital gains (assets held for more than a year) are taxed at 0% and can reach 20% for high incomes. Compared to standard income rates, this translates to potentially large tax savings.
However, you must not overlook the following nuances while calculating tax on goodwill:
You must keep the goodwill for over a year to qualify for lower capital gains rates. Short-term gains are taxed at the ordinary income rate.
Some states impose capital gains taxes, which increase your tax liability.
Under depreciation recapture rules, a portion of the gain might be taxable as ordinary income if you previously depreciated the goodwill.
Remember, getting the most out of your business exit requires an in-depth valuation. Use our Business Valuation Calculator to get a real-time estimate of what your company is worth.
Tips to Maximize Your Goodwill Asset Valuation
Before we move any further, here are some expert-backed tips and hacks to skyrocket your goodwill value:
Maintain Accurate Financial Records
Enhance Brand Reputation and Recognition
Strengthen Customer Relationships
Develop Proprietary Technologies or Processes
Focus on Market Positioning and Competitive Advantage
Demonstrate Consistent Revenue Growth
Optimize Operational Efficiency
Cultivate a Strong Management Team
Secure Long-Term Contracts or Agreements
Document Intellectual Property and Patents
Now, let’s take a deeper dive into the taxation of goodwill using the installment sale approach.
Installment Sale Method and Goodwill Taxation
Managing the tax implications is essential when selling a firm, as it often involves major profits. The installment sale method helps spread the tax on goodwill and other capital gains over several years, thus lowering your tax liability.
What Does the Installment Sales Method Mean?
Instead of receiving the full sale price up front, this method enables you to recognize gain on the sale of an asset (like your company) in proportion to the payments received. In other words, rather than reporting the entire gain in the year of sale, you report a portion each year as you get payments.
Applicability Conditions to Tax on Goodwill
Here are the conditions for the applicability of tax on goodwill:
You need to get paid at least once after the year of sale to be eligible for the installment sale method and postpone paying goodwill taxes.
Amounts allotted to goodwill within the total purchase price must also be clearly stated in the sale agreement.
The installment approach applies only to specific assets. Therefore, goodwill must be readily identifiable.
Finally, the buyer's initial payment can be at most 30% of the sale price. This regulation ensures huge upfront payments don’t hamper the goal of spreading out the tax impact.
Advantages of Installment Sale Treatment
When selling a firm with goodwill, the installment sale approach offers an exceptional chance to reduce your tax burden. However, before deciding, we recommend grasping its potential benefits and limitations.
Here are the benefits of the Installment Sale Method:
1. Reduced Tax Liability
Spreading the gain on goodwill (and other capital gains) over multiple years can reduce your tax burden each year. This approach allows you to move into a lower tax bracket and reduce your tax impact.
2. Better Cash Flow
Deferring taxes on a percentage of the sale price, you keep more money upfront, boosting your financial flexibility and liquidity. You can invest in up-and-coming startups, manage personal bills, or have more financial security.
3. Flexibility During Negotiations
The installment option gives you more freedom in setting payment conditions with the buyer. You can personalize the installments to your own financial needs/goals and secure a term that works best for you.
Limitations of Installment Sale Treatment
Let’s move on to the major limitations of the Installment Sale Method for taxation on goodwill:
1. Interest Accrual
Remember, you’ll most likely owe interest on the deferred tax liability. Even while there may be major tax savings, the accrued interest could offset those gains. Our recommendation? Carefully assess whether the method still benefits your cause.
2. Complex Procedures
It requires highly accurate record-keeping and tax planning to ensure proper reporting and regulatory compliance. This can take a lot of time and additional specialized knowledge.
3. Not Invariably Ideal
Depending on your financial condition and tax status, the potential benefits of the installment plan may not outweigh the complications and interest expenses.
Expert Assistance in Goodwill Taxation Matters
We've learned that selling a firm isn’t easy; numerous factors are considered while finalizing the deal. Understanding goodwill tax is the most neglected, but it’s crucial.
Representing future earnings potential, it offers unique tax problems that must be handled with professional help.
Why Seek Expert Guidance Through the Exit Process?
Here are four key reasons why expert consultation would be your best resort during these situations:
Maximizing Tax Benefits
There are layers to goodwill taxation, such as classification, valuation methods, and depreciation recapture rules. Qualified professionals can help maximize potential capital gains treatment, lower ordinary income taxation, and explore strategic planning alternatives to reduce your tax liability.
Accuracy and Compliance
Valuing goodwill accurately and identifying the proper tax treatment is critical for avoiding costly errors or fines. M&A specialists have the knowledge and experience to ensure you comply with applicable legislation and reporting obligations.
Gaining an Advantage in Negotiations
Learning the ABCs of how goodwill is taxed when selling a business improves your negotiating power. Experts can help structure the sale to leverage certain tax treatments, increasing the final sale price and your profits.
Peace of Mind
Selling a business is stressful, and tax concerns can add to the pressure. Consulting with an expert reduces stress by offering clarity, guidance, and support throughout the M&A process.
At Exitwise, we hire experienced M&A professionals who understand the complexity of goodwill taxes and how it affects your business sales. Read more about how it works to understand our process better.
Frequently Asked Questions (FAQs)
Before we wrap up, here are some of the most important FAQs about how goodwill is taxed when selling a business:
Do You Depreciate Goodwill?
Unlike tangible assets such as machinery or buildings, goodwill cannot be depreciated for tax reasons. You can't deduct its value over the years to lower your taxable earnings. When you sell your business, the gain on goodwill is often classified as a capital gain, potentially resulting in lower tax rates than regular income.
Are There Different Tax Implications for Personal vs. Enterprise Goodwill?
When considering the taxation of goodwill, first try to understand what the personal and enterprise variants generally mean.
Personal goodwill captures the intangible value of your own reputation, experience, and skills. Any gain on this kind of goodwill usually comes under ordinary income. This means it is taxed at your ordinary income tax rate.
Enterprise goodwill, on the other hand, indicates your firm’s total intangible value (not yours). This includes your customer base, brand awareness, and established relationships. This sort of goodwill is frequently eligible for capital gains treatment. This means the seller deals with lower tax rates than ordinary income.
What Records Should Business Owners Keep for Tax Purposes Related to Goodwill?
Accurate tax reporting on goodwill requires meticulous record-keeping. Always keep the following documents readily available:
Business acquisition and sale agreements that specify the entire transaction price and the exact amount assigned to goodwill
Financial statements track previous earnings and other key figures used in evaluating goodwill.
Appraisal reports for documentation (provides unbiased valuation support)
Tax records related to goodwill sales and treatment
NOTE: These are only basic recommendations; certain situations might require additional record-keeping.
Conclusion
Want to ensure a successful and tax-efficient business sale? Understand how goodwill is taxed and the resulting record-keeping obligations. While this blog has offered helpful insights, remember that negotiating the complex nature of taxation on goodwill requires professional assistance. You need to know whom to hire to sell your company successfully.
That's where we come in. Exitwise is ready to help you hire a dedicated team of M&A experts and tax specialists to guide and oversee every step of your business sale, including the complexities of goodwill taxes. Connect with us with us, and let us show you how.
