How is Goodwill Taxed When Selling a Business?
The COVID-19 pandemic has made it more difficult for many businesses to operate profitably. However, some industries have thrived during the pandemic, and companies with loyal customers and brand awareness are attractive to buyers.
Selling your business may be the largest financial transaction you ever complete, and you need to understand how the sale is taxed. Goodwill is often generated when a business is sold, and selling goodwill in a business impacts your taxes.
To understand the tax impact of a business sale, you must first review the difference between realized gains and recognized gains.
Realized Gains Vs. Recognized Gains
A realized gain is recorded when you buy an asset and sell it for an amount greater than the cost. If you purchase 100 shares of IBM common stock for $40 and sell 100 shares at $65, you have a $2,500 realized gain. However, not every realized gain is recognized.
When a gain is taxed, it is a recognized gain. If, for example, the IBM stock is sold in a retirement plan account, the taxation of the $2,500 gain is deferred until the owner takes a distribution, or until a specific retirement age. A deferred gain is realized (there is a buy and a sell), but not recognized for tax purposes until a later date.
Consider these types of business sales, and the differences in tax treatment:
Reviewing Stock Sales And Asset Sales
In a stock sale, the buyer purchases the seller’s entire business, which is defined as all of the company’s stock. An asset sale, on the other hand, refers to the purchase of specific business assets, not the entire company.
How A Stock Sale Works
For this example, assume that Julie sells Sunshine Landscaping for $2,000,000, and that Julie is the sole owner of Sunshine.
If the sale price is greater than the cost basis of the stock, the seller must recognize a gain, which is taxed as a capital gain. In this case, Julie’s cost basis is $1,300,000, and the sale generates a $700,000 gain.
When the seller’s holding period is a year or more, the capital gain is long-term. Julie has operated Sunshine for 5 years, and the $700,000 gain is a long-term capital gain. Short-term gains may be taxed at a different rate than long-term gains.
A stock sale has a drawback for the purchaser, because the buyer cannot deduct any of the purchase price until the stock is sold. A buyer wants to recover the purchase cost quickly, and a stock sale makes the process difficult.
Many owners buy companies through an asset sale, which allows the buyer to recover the cost of the business sooner.
Completing An Asset Sale
Buyers often purchase inventory balances, fixed assets, and intangible assets (patents, copyrights, trademarks) through asset sales.
To illustrate, Sunshine Landscaping sells trucks, stump grinders, and other equipment to another landscaping company for $400,000. Julie calculates the book value of the assets as cost less accumulated depreciation. The $400,000 sale price less $270,000 book value is a taxable gain of $130,000.
If your business sale generates goodwill, that will be another variable that impacts the taxes you pay on a sale.
What Is Goodwill?
Goodwill is the dollar amount paid for a business that is greater than the fair market value of net assets. Here’s an example that explains the steps required for the sale of goodwill:
Adjust Balance Sheet To Fair Market Values
The balance sheet is based on the balance sheet formula (assets = liabilities + equity). To calculate goodwill, you must adjust each of the asset and liability accounts to fair market value.
Let’s assume that the fair market value of Standard Machinery’s assets total $5,000,000, and that the fair market value of liabilities equals $3,800,000. The fair market value of net assets (assets less liabilities) is $1,200,000.
Calculating Goodwill For A Purchase
Assume that Premier Manufacturing purchases Standard Machinery for $1,800,000. The amount paid that is greater than the fair market value of net assets is recorded as goodwill on Premier’s books. Goodwill is ($1,800,000 - $1,200,000), or $600,000, and the purchaser records goodwill and amortizes the balance over a period of years.
Taxation Of Goodwill
Goodwill is taxed to the seller at capital gains tax rates. The tax rates on capital gains have changed several times over the last 20 years, and it’s important to discuss the current capital gains tax rates with a CPA.
Taxes are just one of a number of issues to consider when you sell your company. Operating a business, particularly during a pandemic, is challenging, and you may not have the time or expertise to work on a company sale. Find a business broker who can guide you through the entire process, and help you close a successful sale.
Work With An Expert
The experts at Raincatcher have worked on over 9,200 business sales over 30 years. Their goal is to help entrepreneurs sell remarkable companies.
The brokers will help you assess your business, and suggest changes to increase your company’s value. They use their established network to find qualified buyers, and market the business on your behalf. Raincatcher’s brokers have the expertise required to sell your business at an attractive price, and in less time. Work with Raincatcher to gain peace of mind regarding the successful business you’ve spent so much time and effort building.