Key Takeaways

  • Goodwill represents the intangible value of a business, including brand reputation, customer relationships, and other non-physical assets.
  • Goodwill can be either business or personal, with important tax implications depending on its classification.
  • Structuring the sale of goodwill properly can help avoid double taxation and ensure capital gains treatment.
  • Goodwill sale contracts should explicitly outline the nature of goodwill, valuation terms, and non-compete agreements.
  • Personal goodwill must be clearly supported with evidence of owner-based value such as client relationships or individual reputation.
  • Non-transferable assets and licensing constraints should be considered in asset sales involving goodwill.

The sale of business assets goodwill refers to an intangible aspect of the business. It is not easily defined, but it can be described as the value of a business or trade that will keep customers shopping or purchasing. This is due to the name or reputation of the business or some other factor.

Tax Concerns When Selling a Business

Selling your business can be a difficult and complicated process. There is typically a long list of business and personal issues that have to be considered. This can be extensive and sometimes confusing. Taxes you have to pay when the business sells are one of the primary things people worry about. If you properly structure things, this can minimize the taxes you owe. For reference, ordinary tax rates for a corporation are 35 percent and capital gains can range from 15 to 20 percent.

If you sell a traditional corporation or an S corporation that has profits and the proceeds of the sale will be distributed to the shareholders, the sale of assets will usually result in double taxation at both the corporate and personal tax levels. If you structure this sale more strategically, the sale of goodwill will only be taxed one time at the individual level and subject to the lower rate for capital gains.

During the sale of a corporation's assets, there will be income realized and taxes will be paid by the corporation. When those proceeds are distributed and the business closes its doors, the shareholders will be taxed on their capital gains. Capital gains are the share of sales proceeds over their corporate stock tax basis. If a business's goodwill is personal goodwill, it will only be taxed at an individual shareholder level. Whether or not it's considered a personal asset relates to whether the earning power of the business is related to its abilities or the personal relationships of the owner.

Structuring Goodwill in Asset Sales

When structuring a business asset sale, goodwill must be allocated with precision. Buyers and sellers often negotiate how to allocate the total purchase price among tangible and intangible assets, including goodwill, because it directly impacts the tax consequences for both parties. From the seller's perspective, allocating more value to goodwill typically results in favorable capital gains treatment. For the buyer, amortizing goodwill over 15 years (as per IRS Section 197) can result in long-term tax deductions.

The allocation must be reasonable and reflect economic reality. If not, the IRS may challenge the classification, potentially recharacterizing some of the goodwill as compensation or another form of ordinary income. This underscores the importance of substantiating goodwill valuation through appraisals, contracts, and a detailed record of the business's performance and reputation.

Factors That Determine Goodwill

IRS Rev. Rul. 59-60 states that a company's goodwill can be determined by a number of factors, including:

  • The prestige of the business
  • Earning capacity
  • Ownership of a respected and well-known business name
  • A reputation for successful operations over a long period of time

Traditionally, goodwill is considered a business asset. However, it has been declared a personal asset in several recent Tax Court decisions. This allows a sale of goodwill assets to be declared a capital gain and taxed only once and at a lower rate.

Personal vs. Enterprise Goodwill

A key distinction in goodwill sale contracts is between personal goodwill and enterprise (or business) goodwill:

  • Personal Goodwill refers to the value directly attributable to the owner's personal relationships, skills, or reputation. It is not transferable without the owner's continued involvement or specific agreements, and it can often be treated as a personal asset for tax purposes.
  • Enterprise Goodwill, by contrast, belongs to the business entity. It includes aspects like brand recognition, operational systems, or institutional customer loyalty.

For personal goodwill to be recognized, a seller should not be under a non-compete agreement at the time of the transaction, and documentation (e.g., letters of intent or personal service agreements) should clearly support that the goodwill resides with the individual, not the entity.

Goodwill vs. Going-Concern

Do not confuse goodwill with going-concern value. These are two different elements of a business. Experts typically define what is going-concern value based on the fact that a business will still operate in a way that aligns with its intended purpose rather than fail or be liquidated. In contrast, business goodwill is typically seen as good customer service, reputation, or products, all of which are important.

Legal Components of Goodwill Sale Contracts

Goodwill sale contracts should clearly delineate the specific terms around the goodwill being transferred. Essential components include:

  • Definition of Goodwill: Clearly define what constitutes goodwill in the context of the sale.
  • Allocation Schedule: Specify how much of the purchase price is assigned to goodwill, in compliance with IRS Form 8594.
  • Non-Compete Clauses: Often included to protect the buyer’s investment in goodwill, particularly when personal goodwill is involved.
  • Confidentiality & Non-Solicitation Provisions: To preserve the value of transferred client lists, proprietary knowledge, or market position.
  • Assignment Limitations: If goodwill is tied to individual relationships, contracts should acknowledge any limitations on transferability.

The enforceability of non-compete clauses, in particular, varies by state and should be carefully reviewed by counsel during contract drafting.

Examples of Goodwill That Drive a Business's Core Value

There are a number of elements that make up a business's goodwill:

  • Local economy
  • Reputation
  • Location
  • Phantom assets
  • Custom-built factory
  • Trade secrets
  • Tooling
  • Growing industry
  • Low employee turnover
  • Mailing list
  • Management
  • Contracts
  • Royalty agreements
  • Computer databases
  • Franchises
  • Licenses
  • Advertising materials
  • Copyrights

While many different factors can make up goodwill, it's important to remember that what it is and how it is represented on a business's financial statements are two different things.

Before you purchase a business or put one up for sale, it's best to speak with a professional first. While goodwill may represent the hard work of a business owner, that hard work needs to be accounted for in a different manner and with more detail than in prior years.

There are situations where assets sales are not ideal. If the business holds a license that is nontransferable, it will be of no benefit for you. An example is a liquor license or a government contract that took a number of years to finally secure.

Real-World Use of Goodwill Purchase Agreements

Goodwill sale contracts are frequently used in professional services industries such as dentistry, accounting, and consulting—where personal goodwill plays a significant role. For instance, in the case of SpendSmart Networks, Inc., the goodwill purchase agreement explicitly separated goodwill from other assets and laid out terms for how the seller would transition client relationships post-sale.

In these contracts, goodwill can be monetized by agreeing to specific client handoff procedures, involvement in transitional services, or licensing use of the seller's name or brand for a limited period. These practices help maintain continuity and ensure the buyer retains the value of what they purchased.

How Goodwill Is Derived

The IRS has a classification of how to break down assets into different classes when you are selling a business. Once you have allocated all assets to Class I through Class VI, the leftover amount is considered goodwill. For example, if you are purchasing a business for $300,000 and all your assets total $200,000, then the purchase includes $100,000 in goodwill.

IRS Reporting Requirements and Form 8594

Both buyer and seller must file IRS Form 8594 (Asset Acquisition Statement) when a sale involves goodwill. This form requires both parties to report how the purchase price was allocated among the seven IRS-defined asset classes, with goodwill falling under Class VII.

Consistency in reporting between the buyer and seller is crucial. Inconsistencies may trigger IRS audits or reclassifications. Documentation such as appraisals, contracts, and transition plans can provide critical support for the allocated goodwill value.

Frequently Asked Questions

  1. What is included in goodwill during a business sale?
    Goodwill includes intangible assets such as brand reputation, customer relationships, trade names, and operational efficiencies that cannot be individually identified or separated.
  2. How is goodwill taxed in an asset sale?
    Goodwill is generally treated as a capital asset and taxed at favorable capital gains rates if classified properly, though misclassification could result in ordinary income taxation.
  3. What makes goodwill personal rather than business-related?
    If the value depends on the seller's personal skills or relationships—and is not transferable without them—it’s likely personal goodwill. Documentation is key to substantiating this claim.
  4. Can goodwill be sold independently of other assets?
    Yes, especially in professional practices. A goodwill sale contract may outline the sale of client relationships or reputation alone, separate from physical assets.
  5. Why are non-compete clauses important in goodwill sale contracts?
    They protect the buyer’s investment in goodwill by ensuring the seller doesn’t compete for the same customers post-sale, preserving the value of what was purchased.

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