Q: About five years ago I bought a company’s fortune for $ 2.2 million. Both the seller and I filed an IRS Form 8594 to report how these costs were allocated to specific assets. The contract stipulated that we would report the same assignment to the IRS. This included $ 800,000 for goodwill and $ 220,000 for customer lists. I’ve written off both costs over 15 years. I am now selling the fortune for $ 3.4 million. We also make an agreement on how the costs will be shared. The buyer doesn’t think anything should be assigned to the customer lists. The draft contract provides for $ 1.9 million in goodwill. I will definitely make a large tax gain, but I took amortization deductions of $ 280,000 on the goodwill, so this allocation will make a gain of $ 1,380,000 on the goodwill only. I am ready to do so if the tax law allows a favorable tax rate to be applied. I was told that goodwill is a capital asset and I will have capital gain. This would be taxed at 20% for me and the 3.8% capital gains tax should not apply. This is my retirement and if the tax cost is much higher then I am not sure I can agree to this deal. Can you at least give me an outline of how this is taxed?
A: You need to hire a knowledgeable advisor to look at this business from a general point of view and provide specific advice. I’ll give you an overview and add a tax quote that may save your advisor time.
Also understand that there are many problems associated with selling a business and I can only address the very limited problems that you address.
Subject to this caveat, I will make a few observations. First, the biggest issue you are addressing is the nature of the gain on goodwill. Tax officials use the word “character” to refer to ordinary income or capital gain.
The tax law provides that a favorable tax rate applies to certain types of income, including a so-called “net capital gain (NCG)”. An NCG can include a long-term capital gain, but also a “Section 1231 gain”.
Selling a capital asset held for more than a year may result in long-term capital gain, and selling an asset under Section 1231 for a profit under Section 1231. Either type of profit may qualify for a cheap rate.
Capital losses can only be used to offset capital gains and are otherwise capped at $ 3,000 per year. Section 1231 losses are permitted indefinitely.
Some people then say that the assets of Section 1231 bring out “the best of both worlds.” Both profits and losses are tax-privileged. This is important to you as your goodwill is a Section 1231 asset rather than a net present value.
Section 1231 Real estate is depreciable real estate that is used in a trade or business, or real estate (i.e. even land) that is used in a trade or business. Section 1231 property must be held for more than a year to qualify, so the definition does not include long-term or short-term properties.
The goodwill can be “amortized” because it is intangible property. Only real assets can be written off. Goodwill is not depreciable in the pure sense of the word.
However, tax law (1.197-2 (g) (8)) states that goodwill is treated in the same way as depreciable property. It is more of a Section 1231 asset than a net present value. This also means that previously claimed depreciation can be “re-recorded” as ordinary income.
Your proposed $ 1,380,000 gain is a Section 1231 gain, but $ 280,000 will be taxed at normal tax rates. This is because the $ 280,000 amortization deduction reduced your input tax at normal rates. That previous benefit of $ 280,000 is then “reclaimed” as the same character.
The approximately $ 143,000 that remains on your customer list can be claimed as a normal loss under Section 1231. You could push for a $ 143,000 allocation to client lists if you think claiming a loss might raise an IRS eyebrow, but that’s probably not necessary.
The 3.8% surcharge on investment income should not apply to your profits. This is because the assets sold were corporate assets rather than investments.
Jim Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.