taxes

Valuing goodwill

George Saenzq_v2.gifDear Tax Talk,
How do you measure the gain on the sale of a business when a large part of the value of the business is the customer list, and the promise to work for the buyer for a time to familiarize the customers with the new owner, and the owner with the products, and the way of conducting the business?

I am stumped as to how the measure the "goodwill" part of my business, if any, and the value to place on my time while I am working with the owner after he buys the business. Can you help? What part would be capital gain and what part would be ordinary income on the sale?
-- Pat

a_v2.gifDear Pat,
When a business is sold, generally the buyers and sellers determine the total price to be paid, taking into account various factors. Sometimes the sales contract allocates the purchase price to the various assets and sometimes it doesn't.

The buyer and seller have conflicting interests in a sales contract: The buyer would like to deduct as much upfront as possible through ordinary deductions. This results in ordinary income to the seller. The seller wants allocation to capital gain property, which the buyer may have to recover through tax deductions that stretch over 15 years.

The IRS previously spent a lot of resources in determining the proper allocation of selling price. The IRS effectively got out of the valuation allocation argument when Congress enacted Section 197 around 15 years ago.

Under Section 197, the balance of the purchase price that cannot be assigned to cash or equivalents, receivables, inventory or fixed assets is assigned an amortization period of 15 years and is capital gain to the seller. This is considered goodwill. Goodwill is the value of a trade or business based on expected continued customer patronage due to its name, reputation or any other factor.

Typically a seller will stay on to perform the functions you describe. Sometimes the counsel is part of the purchase price and other times it is part of an employment contract defining specific duties.

The parties are pretty much free to set a salary as a separate consideration or leave it as part of the purchase price. Generally, a seller will demand a salary and forsake capital gain if the employment contract is open-ended. Again, because the buyer and seller have conflicting interests in the allocation, the IRS has pretty much given up the allocation business.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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