“Goodwill” is defined generally as that value of your business that is over the simple measure of the value of the assets of the business. We’ll get deeper into how to define goodwill in a second.
When Is Goodwill Valued?
In talking about goodwill, it’s generally in the context of a business sale. When a business sells its assets, we can put a pretty accurate value on those assets – liquidation value, it’s called. Like pricing a used car, a business’ equipment and assets can be assigned a value, and the value totaled up for a purchaser. Unless you’re doing a fire sale of the business, though, there is an intangible value added to the purchase price which is known as goodwill.
The purchaser of a business pays extra because it’s your business, that you’ve built into a successful business. They are buying that success and proven record which resulted in the revenue stream the business makes.
There is a pipe/cigar store I go to when I’m in Chicago. It’s been there over 100 years. Everyone knows the place, the owners are experts in what they sell. The assets of the business, though, are nominal – inventory, display cases, furniture, maybe some office systems.
But the business, if they sold it, would be worth probably a few million dollars because of its reputation and proven success.
That’s goodwill, and that’s what you pay for when you buy a business.
Conversely, if you run the only waste incinerator in a five county area, nobody is going there because you own the business. They’re not there to hear your expertise. Customers are going their because you are the only waste incinerator in a five county area.
A business like this has much less of a goodwill value if it were to be sold. The equipment is worth something, the record of its revenue stream is worth something, but there may not be a premium based on goodwill.
What Is Goodwill?
It’s made up of many factors. I encourage clients to work with a qualified business CPA when valuing their business. Importantly, goodwill is taxed differently than ordinary income, so it’s important to structure asset sales most tax efficiently.
Broadly, the IRS looks to many factors when determining if a valuation of goodwill is taxable at the lower long term capital gains rate rather than as personal income. Factors include: age of the company; whether it has long term employees adding value to the business. It also includes the position of the business in the market – is it just another nail salon among dozens, or is it one of only three cigar shops in the downtown area because no one else could compete with it?
The IRS will look to factors like banking relationships and the availability of finance. Potential growth of the business is another factor in determining the value of goodwill. It may even include whether or not the “personality” that created the business is staying on post-purchase for a while to ease the new owners into the penumbra of the goodwill of the seller.
We collect evidence of all these when valuing goodwill, so that if the IRS comes looking we can show the evidence of these factors to them. This shows that the valuation was reason-based and not just made up.
Conclusion
There are many potentially expensive tax implications when valuing the sale of a business. This includes valuing goodwill. I don’t value goodwill for clients because of that – I refer them to a qualified CPA. Valuing goodwill is a process, not an event. Involve myself and your CPA early when selling a valuable business.
Contact me if you have any questions on selling your business or any other business transaction. In western North Carolina, Asheville, Waynesville, Hendersonville at (312) 671-6453.
Email me at: palermo@palermolaw.com.
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