Selling a business is an arduous endeavor that involves in-depth financial and tax processes from start to finish. One key element of the transaction is how to value and tax goodwill, as this can impact the amount of your tax bill upon closing.
This article will explain how goodwill is valued and taxed when selling a business. By the end, you should clearly understand what qualifies as a goodwill asset, how to evaluate its worth and how it will be taxed at the time of sale.
What Is a Goodwill Asset?
A goodwill asset is a non-physical, intangible asset that increases a business’s purchase price beyond its physical or tangible assets’ estimated market value. It is the amount of money a buyer pays above the fair value market price in the sale of a business.
Goodwill assets are business assets unique to the business being sold and cannot be purchased, sold, or created outside its original company.
However, a seller can only realize goodwill assets if their company is sold at a price higher than its net asset value.
Why does goodwill matter when selling a business? Goodwill asset value matters because the tax rate applied to this asset type is generally lower than the tax rates of other intangible or physical assets upon completion of the sale of the business.
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Examples of Goodwill Assets
Examples of intangible assets that can be classified as goodwill in the sale of a business include:
- Brand reputation
- Earning capacity
- Customer loyalty
- Employee retention
- Intellectual information
- Longevity
According to IFRS and US GAAP accounting standards, for an asset to be declared a goodwill asset, it must:
- be an intangible asset
- with an indefinite lifespan
What do you mean by an indefinite lifespan? In accounting, indefinite lifespan refers to an asset where its rate of capital depreciation isn’t known or cannot be easily calculated.
Goodwill Assets vs. Intangible Assets
The terms goodwill asset and intangible asset are often used interchangeably. This is understandable because outside of taxation laws and regulations, an intangible asset and a goodwill asset are essentially the same.
However, when determining how to tax the capital assets of a business sale, the two classifications are different and depend on the specific tax scenario being processed.
An intangible asset only becomes a goodwill asset if it meets the criteria of a goodwill asset when a business is exchanging ownership, such as in the sale of a business. If an intangible asset meets the requirements of a goodwill asset, it will be taxed as such when the company’s sale of assets is finalized.
However, when filing an annual income tax return, that same intangible asset may be classified as an intangible, operating, or fixed asset. In those circumstances, it will be taxed based on the current intangible asset tax rates.
Are All Intangible Assets Goodwill?
No, only intangible assets without a defined lifespan or ones that cannot be sold separately from the business can be classified as goodwill assets when selling your business.
Examples of intangible assets that do not meet the requirements of a goodwill classification include:
- Patents
- Achieved certifications and standards
- Intellectual property, such as a secret recipe or musical composition
Intangible assets that do not meet the requirements of a goodwill asset will likely be subjected to capital gains taxes when a business is sold.
How Do Businesses Acquire Goodwill Assets?
A goodwill asset is achieved through years of work spent developing initiatives for the purpose of long term capital gain. This can include nurturing customer, employee, and partner relationships or developing proprietary information and processes.
Any established personal goodwill assets may add value to the selling price above and beyond its net worth when selling a business. This is because goodwill assets demonstrate the business’s potential to be successful and profitable after ownership exchanges hands.
How is Goodwill Value Determined?
A Simple Calculation in Principle
Goodwill asset value is determined after a sale is complete and is based on the final sale price and the company’s physical assets.
The simple calculation detailed below is the commonly understood formula used to determine how much the purchaser paid for the goodwill assets at the time of sale.
Goodwill = P− (A − L )
where:
P=Purchase price
A=Fair market value of assets
L=Fair market value of liabilities
T-Mobile/Sprint Merger: A Real Life Goodwill Valuation
In 2018, T-Mobile acquired Sprint to the tune of $35.85 billion. At the time of the acquisition, the fair market value for the Sprint corporation was determined to be $78.34 billion with liabilities of $45.56 billion.
Using the goodwill valuation calculation above, we can easily see that the goodwill asset value of the T-Mobile/Sprint merger was $3.07 billion.
A Challenging Endeavour in Practice
While the above formula appears simple enough, accountants struggle to find consistency when determining goodwill asset value. This is primarily due to many unknowns regarding future cash flows present at the time of acquisition.
Having accurate and timely financial reports prepared before listing your business for sale is a sensible way to alleviate potential headaches once a deal closes. Financial consultants specializing in business sales can help prepare your financial records to maximize goodwill asset value.
How Is Goodwill Taxed When Selling a Business?
Goodwill assets are generally put under the tax umbrella of long-term capital gains when selling a business. This is good news for business owners because the tax rates for a long-term capital gain investment are less than other asset tax rates, such as short-term capital gains.
Short and Long-Term Capital Gains Tax Rates for 2023
- The long-term capital gains tax rate ranges from 0% – 20%.
- The short-term capital gains tax rate ranges from 10% – 37%
Goodwill Tax Implications When Selling Your Business
The tax implications of a goodwill asset sale are complex and should be evaluated by an experienced CPA or financial advisor. A qualified CFO can provide valuable insight into how to best structure the sale of your business to reduce the amount of taxes you end up having to pay.
5 Tips to Maximize Your Goodwill Asset Valuation
When selling your business, you want to put the company’s best foot forward and make it as appealing as possible to potential buyers. This means ensuring your financial books are in pristine order, knowing your company’s valuation, and showcasing your company’s unique intangible assets.
To boost your business’s intangible asset value and potentially generate more goodwill asset value, try the following five tips:
- Foster a positive brand image. Work on building a solid brand identity before you list your business for sale.
- Engage with the community. Actively engaging with your local community and finding ways to give back can help garner local support, which is appealing to potential buyers.
- Invest in your employees. A strong and skilled workforce is valuable to investors looking for a turnkey business to purchase.
- Put your customers first. Providing consistently excellent customer service means customers are more likely to choose you next time they look for similar products or services. Being able to demonstrate a strong customer base will entice buyers to pay more for your business.
- Enlist Financial Guidance. Selling a business is a huge undertaking that should be done with care and expert guidance. Financial experts can evaluate your business and offer suggestions to increase its goodwill asset potential.
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Ready to List Your Business?
If it’s time to sell your business, it’s time to get the right advice to maximize the value you receive for your intangible assets, earn top dollar on the sale of your business, and lower the amount of taxes you end up paying.
A financial expert can help you make the most of your goodwill asset before you put it up for sale. Doing so might give you a significant tax break and increase the value of your company’s assets. Michigan CFO Associates understand how to maximize the value of goodwill assets through effective financial and CFO services.
Contact us today to learn how we can help.
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