goodwill

How to Drastically Reduce Taxes by Allocating Goodwill

You may hear the word “Goodwill”  thrown around a lot, especially during business valuation and/or buying and selling a business, but what does it really mean?  When it comes to selling your business, the term refers to all the “sweat equity” that the seller put into a business during his/her ownership tenure. Goodwill can be thought of as the difference between the various tangible assets that a business has and the overall purchase price.

The M&A Dictionary defines goodwill in the following way, “An intangible fixed asset that is carried as an asset on the balance sheet, such as a recognizable brand, product name, or strong reputation. When one company pays more than the net book value for another, the former is typically paying for goodwill. Goodwill is often viewed as an approximation of the value of a company’s brand names, reputation, or long-term relationships that cannot otherwise be represented financially.”

Goodwill vs. Going-Concern

Now, it is important not to confuse goodwill value with “going-concern value,” as the two are definitely not the same. Going-concern value is typically defined by experts, as the fact that the business will continue to operate in a manner that is consistent with its intended purpose as opposed to failing or being liquidated. For most business owners, goodwill is seen as good service, products and reputation, all of which, of course, matters greatly.

Below is a list of some of the items that can be listed under the term “goodwill.” As you will notice, the list is surprisingly diverse.

42 Examples of Goodwill Items that Drive Core Value

  • Phantom Assets
  • Local Economy
  • Industry Ratios
  • Custom-Built Factory
  • Management
  • Loyal Customer Base
  • Supplier List
  • Reputation
  • Delivery Systems
  • Location
  • Experienced Design Staff
  • Growing Industry
  • Recession Resistant Industry
  • Low Employee Turnover
  • Skilled Employees
  • Trade Secrets
  • Licenses
  • Mailing List
  • Royalty Agreements
  • Tooling
  • Technologically Advanced Equipment
  • Advertising Campaigns
  • Advertising Materials
  • Backlog
  • Computer Databases
  • Computer Designs
  • Contracts
  • Copyrights
  • Credit Files
  • Distributorships
  • Engineering Drawings
  • Favorable Financing
  • Franchises
  • Government Programs
  • Know-How
  • Training Procedures
  • Proprietary Designs
  • Systems and Procedures
  • Trademarks
  • Employee Manual
  • Location
  • Name Recognition

As you can tell, goodwill, as it pertains to a business, is not an easily defined term. It is also very important to keep in mind that what goodwill is and how it is represented on a company’s financial statements are two different things.

Here is an example: a company sells for $2 million dollars but has only $1 million in tangible assets. The balance of $1 million dollars was considered goodwill and goodwill can be amortized by the acquirer over a 15-year period. All of this was especially impactful on public companies as an acquisition could negatively impact earnings which, in turn, negatively impacted stock price, so public companies were often reluctant to acquire firms in which goodwill was a large part of the purchase price. On the flip side of the coin, purchasers of non-public firms received a tax break due to amortization.

The Federal Accounting Standards Board (FASB) created new rules and standards pertaining to goodwill and those rules and standards were implemented on July 1, 2001. Upon the implementation of these rules and standards, goodwill may not have to be written off, unless the goodwill is carried at a value that is in excess of its real value. Now, the standards require companies to have intangible assets, which include goodwill, valued by an outside expert on an annual basis. These new rules work to define the difference between goodwill and other intangible assets as well as how they are to be treated in terms of accounting and tax reporting.

Before you buy a business or put a business up for sale, it is a good idea to talk to the professionals. The bottom line is that goodwill can still represent all the hard work a seller put into a business; however, that hard work must be accounted for differently than in years past and with more detail.

Generally speaking when you purchase another business, you are only buying the assets of that business. In other words, you are not buying the entity. Why not? Well, the entity could have a lot of skeletons in the closet. If the previous owner had made a mistake on a tax return and that mistake led to $100,000 in damages for the client, as the new owner do you want that responsibility or exposure? Nope.

There are circumstances where an asset sale is NOT ideal. At times the entity holds a license that is non-transferrable such as a liquor license or the entity has a contract with the government that took 7 years to bid and be awarded, and is also non-transferrable. But for most transactions, you will be executing an asset sale.

Within that asset sale is allocation of assets. Buyers and sellers have competing interests on price of course, but they also have competing interests on tax consequences. And to add to the complication, based on each party’s unique circumstances, a buyer and seller’s interests might be in concert with each other. In other words, an asset allocation might provide a favorable tax position for the buyer because of his or her own tax world, while still providing a favorable or at least neutral tax position for the seller. And these issues can affect the purchase price as well.

As business consultants, the Business Acquisition Experts is very aware of these competing interests and how they interplay with price negotiations. Let us help!

Let’s review some basics.

Asset Priority Buyer Seller
Cash Class I NA NA
Investments Class II NA NA
Accounts Receivable* Class III NA Ordinary Income
Inventory, Book Value Class IV NA None
Fixed Assets Class V Amortized, Varies Recapture / Gain
Intangibles Class VI Amortized, 15 Years Capital Gain
Goodwill Class VII Amortized, 15 Years Capital Gain
Non-Compete NA Amortized, 15 Years Ordinary Income
Consulting Agreements NA Expensed Income + SE Tax

* Sellers using an accrual method of accounting would not recognize income for the sale of their Accounts Receivable

The IRS breaks assets into classes, and essentially once you’ve allocated everything to Class I thru Class VI, whatever is left over is then considered Goodwill. So if the price is $200,000 and all your assets add up to $150,000, then you are also purchasing $50,000 in Goodwill.

 

For more on selling your business and how to negotiate the many parameters of a deal contact Business Acquisition Experts today!

 

Copyright: Business Acquisition Experts, Inc.

 

SBA Loans Fact Sheet- Everything You Need to Know to Buy a Business

If you are seeking financing to buy a business this is a must read! If you have
any questions following this please call Cody Weaver (646)737-5273

Buying and Financing a Business can be difficult but it doesnt have to be. Business Acquisition Expertss has the experince you need to make and acquisition with the most favorable terms.

SBA SOP 5010 5 (E) – as it relates to SBA Loans for BUSINESS ACQUISITIONS p. 81 – Acceptable Use of Loan Proceeds: Business Acquisition, Working Capital, Furniture, Fixtures, Machinery, Equipment, Real Estate, Refinance Business Debt

p.153 – Loan Maturity: Maximum Maturity is 10 years unless largest % of assets financed is Real Estate then maturity may be up to 25 years p.

139 – 141 – Change of Ownership “rules”: 1. Change must result in small business applicant purchasing or acquiring 100% ownership interest in business; Non-owner cannot purchase a partial ownership from seller, and existing owner cannot purchase ownership from a partner if transaction does not result in 100% ownership by purchaser;

2. Seller may not remain as officer, director, stockholder or key employee of the business; may contract as a consultant for no longer than 12 months after purchase;

3. Loan applicant must be a business, not an individual;

4. Lender must verify with IRS the last 3 years tax returns of business being sold;

5. Any Real Estate that is part of a change of ownership cannot be financed separately with a non-SBA guaranteed loan unless SBA loan receives a shared lien position on the real property. (Does not apply to SBA 504 program);

6. SBA considers change of ownership to be a “new” business. Lender is required to: a. Obtain a business valuation (*see valuation below) b. Make a site visit of assets being acquired c. Obtain a Real Estate appraisal for any real property acquired d. Analyze how the change of ownership will benefit the business being purchased (not buyer or seller);

7. SBA loan can finance intangible assets (goodwill, client/customer lists, patents, copyrights, trademarks and agreements not to compete, etc.)

a. If purchase price of business includes intangible assets in excess of $500,000, the borrower and/or seller must provide an equity injection (**see equity requirements below) of at least 25% of the purchase price – or a lender cannot process the application using PLP, and the application must be approved through SBA.

b. “Purchase Price of Business” includes all assets being acquired, including any real property, equipment, and intangible assets.

c. Value of intangible assets is determined by either i) book value reflected on business’s balance sheet, ii) separate appraisal for the particular asset, or iii) the business valuation minus the sum of working capital assets and fixed assets being purchased. Susan Kite /

SBA SOP 5010 5 (E) – as it relates to BUSINESS ACQUISITIONS p. 187 – 188 – Equity Requirements:

1. Lender must determine and document adequacy of equity injection.

2. Source of Equity Injection: a) Cash that is NOT borrowed (can be backed by a gift letter if supported by documentation in 3 below);

b) Cash from a personal loan IF repayment of that loan can be demonstrated from sources other than cash flow of business or owner salary from business;

c) Personal assets, other than cash, injected by owners where value is supported by an outside appraisal, not part of business valuation;

d) Debt that is on FULL STANDBY (no payments during term of SBA loan) or debt on PARTIAL STANDBY (interest-only payments being made). Partial Standby debt can only be considered as equity when there is adequate historical business cash flow available to make the interest payments.

3. Lenders must document and verify all equity injection prior to disbursement of loan proceeds. Borrower must provide: a) copy of a check or wire transfer along with evidence that the check or wire was processed showing the funds were moved into the borrower’s account or escrow; b) copy of the statements of account from which the funds are being withdrawn for each of the two most recent months prior to disbursement showing that the funds were available; and c) subsequent statement of the borrower’s account showing that the funds were deposited or a copy of an escrow settlement statement showing the use of the cash.

p. 194–195 – Business Valuation for Change of Ownership: Lender must determine the value of the business in addition to any real estate, which is valued separately through an appraisal.

1. If total amount being financed, minus appraised value of real estate and/or equipment being financed is under $251,000, lender may perform their own valuation;

2. If GREATER than $250,000 or if there is a close relationship between buyer and seller, then lender must request an independent valuation from a “qualified source” that regularly receives pay for business valuations and is either CPA or accredited by a recognized organization listed on page 194 of SOP.

3. Lender may use a going concern appraisal to meet valuation requirement if i) loan is used to purchase a special use property, ii) appraiser is either a “qualified source” or has completed a specific Appraisal Institute course, and iii) appraisal allocates separate values to land, building, equipment and intangible assets.

4. Any amount in excess of business valuation may NOT be financed with the SBA guaranteed loan.

Cody Weaver M&A Adviser at Busines Acquisition Experts
www.acquisitionspro.com

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Business Valuation: Do the Financials Tell the Whole Story?

Many experts say no! These experts believe that only half of the business valuation should be based on the financials (the number-crunching), with the other half of the business valuation based on non-financial information (the subjective factors).

What subjective factors are they referring to?  SWOT is an acronym for Strengths, Weaknesses, Opportunities and Threats – the primary factors that make up the subjective, or non-financial, analysis. Below you will find a more detailed look at the areas that help us evaluate a company’s SWOT.

Industry Status – A company’s value increases when its associated industry is expanding, and its value decreases in any of the following situations:  its industry is constantly fighting technical obsolescence; its industry involves a commodity subject to ongoing price wars; its industry is severely impacted by foreign competition; or its industry is negatively impacted by governmental policies, controls, or pricing.

Geographic Location – A company is worth more if it is located in states or countries that have a favorable infrastructure, advantageous tax rates, or higher reimbursement rates.  A company with access to an ample educated and competitive work force will also enjoy increased value.

Management – A company with low turnover in management and a solid second-tier management team comprised of different age levels is also worth more.

Facilities – A company operating profitably at 70 percent capacity is worth more than a company currently near capacity. Equipment should be up to date and any leases – either equipment or real estate – renewable at reasonable rates.

Products or Services – A company is worth more if its products or services are proprietary, are diversified with some pricing power, and have, preferably, a recognizable brand name. In addition, new products or services should be introduced on a regular basis.

Customers – A company is worth more if there is not heavy customer concentration, but rather recurring revenue from long-time, loyal customers, as well as from new customers created through a regular and systematic sales process.

Competition – A company not contending head to head with powerful competitors such as Microsoft or Wal-Mart will rate a higher value.

Suppliers – Finally, a company is worth more if it is not dependent on single sourced key items or items available from only a limited number of suppliers.

 

Copyright 2012 Business Brokerage Press, Inc.