When you’re selling a business, it’s not as easy as slapping a “For Sale” sign on the front window and waiting until someone hands over some cash. There are countless preparation steps, negotiations, information exchanges, and more that have to be considered.
One of those many variables is “Goodwill”. Goodwill is a slightly complex aspect of the selling process, and it has a major impact on the long-term health of the deal.
In this article, we want to cover how goodwill is taxed when selling a business. Let’s start by determining what goodwill is, how it works, and how you can use it to your advantage.
What is Goodwill When Selling a Business?
In the simplest terms, goodwill is a personal value you’ve gained with your customer base, suppliers, and other parts of your business model that are required for it to function. When you’ve built up quite a bit of it, you can assure your buyer that they will enjoy the benefits of your hard work in the sense that those established supply lines and customers will continue to do business with the company despite the change in ownership.
This “goodwill” is obviously intangible. It’s not a physical asset that the buyer can hold onto and know that it’s meaningful. This can produce some difficulties when you’re trying to use it to your advantage, but it is well worth the effort.
Why is Goodwill Important?
Goodwill is a key component of the selling process because it provides you with the opportunity to reduce the taxes you pay on the sale while maximizing your overall profits. This is because you can handle the goodwill transaction separate from the main asset sale to avoid capital gains rates that would otherwise dramatically raise the amount of taxation you face upon closing the sale.
Since taxes are likely to chip away at a large chunk of your would-be profits, goodwill is a tool most reputable companies should try to take advantage of.
The Problem with Goodwill Assets
Calling back to the first section, you might remember that we said goodwill is an intangible asset; an asset that has no physical existence, yet it can still provide a lot of value to the right buyer.
That produces a bit of a problem sometimes. How do you prove you have goodwill built up with your customers and any other relevant entities?
Well, the main way of proving you have goodwill is via your profits. Whenever you have your company’s value assessed, your excess earnings are typically counted towards your goodwill. These earnings are what goes above and beyond your profit projections, and that helps prove that your customers are more than happy to continue supporting the business and providing substantial profits for the new owner. This is probably the best way to prove to a buyer that your business has built up some goodwill and won’t suddenly tank once the sale goes public.
So, if you’re wanting to take advantage of goodwill sales during your asset liquidation, it’s a wise choice to ensure your net earnings are well above the value of your tangible assets such as your inventory.
How is Goodwill Taxed When Selling a Business?
The taxation involved in business sales is probably one of the most complex forms of taxation you can come across, and you’ll be happy that most middle-market business owners only have to go through it once. However, we’ll break it down for you step by step to help you figure out the best allocation for your assets, both tangible and intangible when selling your business.
Two Taxed Incomes:
First, in regard to your goodwill, it needs to be transferred separately. This is because the IRS will tax you based on two different concepts.
Tangible Assets:
Your tangible assets are taxed like a more complicated version of your standard income tax. All of your tangible assets will typically be sold and taxed separately to avoid being taxed at a massive rate on one big lump sum. This means that your inventory, production equipment, the property, and anything else you can think of will likely be treated as separate, less-costly, transactions.
Keep in mind that, even if you’re just a small business selling for around $500,000, 37% of that will be taken away in the form of taxes. You can imagine how high the percentage, and the actual total, are when you’re talking about asset sales valued in the millions when lumped together.
In fact, this is why most people opt to sell their business as an asset sale. It helps them avoid some of the tax complications that arise in other methods of selling a business.
However, this doesn’t include your goodwill sale. Since your goodwill isn’t something tangible, it doesn’t fit into this tax category. Don’t worry. That’s actually a good thing, and you want to prevent as much of your excess net earnings from being counted with the rest of your assets whenever possible; we’ll go into why in the section below.
Intangible Assets:
In general, outside of the business world, a lot of things can be considered intangible assets. Especially in a world where phrases, ideas, and other non-physical things can have a tremendous value associated with them. For our purposes, we’ll narrow it down to just thegoodwillpart of that.
So, how is goodwill taxed when selling a business?
The goodwill that is sold separately from your tangible assets follows its own set of tax rules, and you can take advantage of that if you do it right.
When transferred on their own as personal goodwill, your excess net earnings are subject to capital gains taxes. Capital gains taxes are the same form of taxes applied to any stocks you have that have grown in value, property that has built value, etc. In any event, the tax percentage applied with capital gains taxes is typically far lower than what you’d have to pay if the same amount of money were taxed as personal income. For example, for the same $500,000 dollars you’d be taxed over 37% when counted as personal income, and you would only have to pay 20% in taxes for capital gains. This scales up to meet whatever your overall net excess earnings are, and when you’re talking about millions of dollars, that 17% difference is huge.
How to Determine Goodwill Before a Sale
There are several factors that will go into building up your goodwill and determining its overall value. Remember, the more goodwill you have, the more you can profit from the sale without having to pay as much tax. So, it’s a good idea to check each of these off as you build your company and grow; if you’re not looking to sell yet, a little foresight can pay off big time.
Prestige:
Your company’s prestige is how respected it is among your customer base and the industry at large. For example, you can look at two mechanic companies.
Dobb’s is a well-known American mechanic shop with chains all around the nation and a very loyal fanbase. Many car owners will only take their vehicle to their local Dobb’s shop because the company has built a reputation for getting the job done right. This is an example of a company having prestige and having earned the respect and loyalty of its customer base, while setting industry standards along the way.
In comparison, look at your local mom-and-pop mechanic shop with one location and four years of service history in the community. Yes, a lot of locals might really like the business, but it hasn’t been around long, it doesn’t have a large customer base that is loyal to it, and it probably isn’t a blip on the radar of other businesses in the industry. It’s not a knock-on companies that meet that description, but they simply don’t have the prestige that would prove goodwill during a sale.
Brand Ownership:
Just the name of a company is enough to boost your goodwill in some situations. It doesn’t even have to be attached to the original company that built the brand’s name into what it is. There are a lot of brand names like this nowadays. If you grew up playing games in the early 90s and even earlier, ATARI is one of them.
We’ll use the ATARI example to explain this one. When ATARI launched, it built a reputation within the industry by developing and publishing classic titles hundreds of millions of people look back on with nostalgia.
Well, right before the turn of the century, the company was purchased by Infogrames, a name you probably haven’t heard of and have no opinions about.
Since Infogrames purchased ATARI and its name, it can produce whatever products it wants and use the ATARI name to generate consumer trust, and ultimately, far more sales. Think about it. Would you buy a new throwback console with “Infogrames” on it, or would the ATARI name grab your attention and support?
This same concept works with anything else, too. When your business is acquired, your business’s name is acquired. If you ensure your brand name means something, you can gain a lot of goodwill.
Longevity:
This one is easy. If your family has been operating your business for four generations without fail, that says a lot about the quality of your business and its long-term potential.
In comparison, a company that opened up two years ago doesn’t have the data to establish a track record. There’s simply not enough opportunity to prove how long a business can last when it hasn’t already been open for a long time, and that damages your goodwill a bit.
Obviously, this isn’t really a thing you can avoid if you’re trying to sell a business shortly after opening it, but if you do hold off on your sale, build up a good reputation, and keep the business growing steadily, it’ll pay off in the long run.
Earning Capacity:
How much can your company earn? That’s one of the biggest determining factors in your business’s goodwill, and it’s why the IRS defines goodwill as the net excess of your earnings; if you’re making a lot of extra profit, you’re obviously doing quite well and pleasing your customers. Early on, this depends largely on how well you can get your product or service to take off, but it should grow steadily over time if you keep at it and build your reputation.
Capital Gains Tax Rates on Goodwill
Goodwill isn’t going to be the same as your total business sale. If you’re selling a $5-million business, only a few hundred thousand might be considered goodwill depending on your tangible assets and a variety of other factors.
Here are the various capital gains tax percentages you can expect for the reasonable amounts of goodwill you’ll likely have:
- 0%: If you’ve only made $41,675 in goodwill, you don’t have to pay any capital gains taxes on that income. Essentially, this is a free $41,000 out of your total sale amount, and if you have a smaller company or one that hasn’t been around long, you’re likely to fall into this threshold.
- 15%: If you exceed the above amount, but stay under $459,750 goodwill value, you only have to pay 15%. If taxed as ordinary income, this can be as high as 27%.
- 20%: Over $456,750, you’ll have to pay 20% in capital gains taxes. This isn’t a number most people want to see when you’re talking about half a million dollars, but it’s far better than the ordinary income percentage of 37%.
As you can see, the tax rate is considerably lower. As long as you’re a middle-market business, you’ll probably fall into one of the smaller thresholds. However, more established middle-market companies can easily work their way to the top of that and experience major savings when closing the sale.
Get Help Allocating Your Goodwill and Maximizing Your Tax Savings
If this explanation on how goodwill is taxed when selling a business sounds a bit complicated, that’s because it is. You have to allocate and transfer the goodwill assets separately from your general business assets, and that’s not always easy to do properly.
If you want help with not just handling your goodwill transaction, but also with the rest of the selling process, contact Final Ascent. We are M&A advisors specialized in helping middle-market companies navigate the selling process and take the stress out of your life’s largest earning event.