Goodwill is the intangible value that a business possesses due to its reputation, customer base, branding, and other factors. In this guide, we will explore the different types of goodwill, how goodwill is taxed for business owners, and what you need to know as a business owner.
What is Goodwill?
Goodwill is an intangible asset that represents the residual value of a business’s reputation, customer base, and established relationships with suppliers and employees. It can be categorized as either purchased or self-created goodwill.
Goodwill is like a bank account where businesses can deposit trust, credibility, and reputation. It’s a valuable asset that can help a company maintain a competitive edge.
Types of Goodwill
How goodwill is taxed for business owners depends on the type of goodwill. Here are the two main types:
This type of goodwill arises when a business is acquired for a price that exceeds the fair market value of its net identifiable assets.
This type of goodwill arises when a business creates its brand, customer base, and reputation through its own efforts without any financial transactions.
How is Goodwill Taxed?
You may be asking, how is goodwill taxed when selling a business? Goodwill is taxed as capital gains when it is sold. The tax rate can vary depending on several factors, such as the tax status of the seller and the length of time the asset has been held.
Calculating Goodwill for Tax Purposes
To fully understand how goodwill is taxed for business owners, we need to go over 4 simple steps of calculating goodwill for tax-related purposes.
Step 1: Determine Purchase Price
The first step is to determine the purchase price of the business.
Step 2: Allocate Purchase Price
The second step is to allocate the purchase price to the various assets acquired, such as inventory, equipment, and patents.
Step 3: Determine the Value of Identifiable Assets
The third step is to determine the fair market value of the identifiable assets.
Step 4: Calculate Goodwill
The fourth and final step is to subtract the fair market value of the identifiable assets from the purchase price to determine the value of purchased goodwill.
Reporting Goodwill on Tax Returns
Goodwill must be reported on the tax return as a long-term capital gain. The seller must file Form 8949 and Schedule D to report the sale. The buyer must also allocate the purchase price to the various assets acquired and report the transaction on Form 8594.
Properly reporting goodwill on a tax return is crucial to avoid costly penalties and to maintain compliance with the IRS. It’s always best to consult with a tax professional.
Tax Implications of Buying or Selling a Business with Goodwill
Buying a Business with Goodwill
When buying a business with goodwill, the buyer can allocate a portion of the purchase price to goodwill. This allocation can be used to reduce the tax liability of the buyer in the future.
Selling a Business with Goodwill
When selling a business with goodwill, the seller will need to pay taxes on the sale of the goodwill as a capital gain. The tax rate and liability can be minimized by reporting the sale properly and by consulting a tax professional.
Examples of Goodwill Tax Treatment
How goodwill is taxed for business owners can vary depending on the circumstances of the sale. Here are a few examples:
Example 1: Self-Created Goodwill
If a business owner sells a business with self-created goodwill for $1 million, and the value of the identifiable assets is $300,000, the goodwill will be taxed as a long-term capital gain of $700,000.
Example 2: Purchased Goodwill
If a business owner sells a business with purchased goodwill for $1 million, and the value of the identifiable assets is $500,000, the goodwill will be taxed as a long-term capital gain of $500,000.