Where to Report Sale of Goodwill on 4797

Q: About five years ago, I bought the assets of a business for $2.2 million. Both the seller and I filed an IRS Form 8594 to report how this cost was allocated to specific assets. The contract required that we report the same allocation to IRS. This included $800,000 to goodwill and $220,000 to customer lists. I have amortized both costs over 15 years. I am now selling the assets for $3.4 million. We are also doing an agreement for the allocation of the cost. The buyer does not believe that anything should be allocated to the customer lists. The draft agreement allocates $1.9 million to goodwill. I will have a large tax gain in any case, but I have claimed $280,000 of amortization deductions for the goodwill so this allocation will create $1,380,000 of gain just for the goodwill. I am willing to do that if the tax law allows a favorable rate to apply. I have been told that the goodwill is a capital asset and I will have capital gain. This would be taxed at 20% to me and the 3.8% investment income tax should not apply. This is my retirement and if the tax cost is much higher, I am not sure I can agree to this deal. Can you give me at least an overview to how this will be taxed?

A: You do need to engage a competent adviser to look at this deal from an overall standpoint and provide specific advice. I will give you an overview and will include a tax law citation that might save some time for your adviser.

Also, understand that there are many issues associated with a sale of a business and I can only address the very limited issues that you raise.

Subject to that caveat, I'll make a few observations. First, the biggest issue you raise is the character of the gain from sale of goodwill. Tax people use the word "character" to refer to ordinary income or capital gain.

The tax law allows a favorable rate to apply to certain types of income, including something called a "net capital gain (NCG)." A NCG can include a long-term capital gain but also a "Section 1231 gain."

The sale of a capital asset held for more than one year can produce a long-term capital gain and the sale of a Section 1231 asset a Section 1231 gain. Both types of gain can qualify for a favorable rate.

Capital losses can only be used to offset capital gains and are otherwise limited to $3,000 per year. Section 1231 losses are allowed without limit.

Some people then say that Section 1231 assets produce "the best of both worlds." Both gains and losses are tax favored. This is important to you because your goodwill is a Section 1231 asset rather than a capital asset.

Section 1231 property is depreciable property used in a trade or business or any real property (i.e., even land) used in a trade or business. Section 1231 property must be held for more than one year to qualify, so there is no long-term or short-term in the definition.

Goodwill is "amortizable" because it is intangible property. Only tangible property can be depreciated. In the pure sense of the word, goodwill is not depreciable.

The tax regulations (1.197-2(g)(8)) nonetheless say that goodwill will be treated the same as depreciable property. It is then a Section 1231 asset rather than a capital asset. That also means any amortization previously claimed can be "recaptured" as ordinary income.

Your proposed $1,380,000 gain will be a Section 1231 gain but $280,000 will be taxed at ordinary tax rates. This is so because the $280,000 of amortization deductions reduced your prior tax at ordinary rates. This $280,000 prior benefit is then "recaptured" as the same character.

The roughly $143,000 left in your customer list can be claimed as an ordinary Section 1231 loss. You could push for an allocation of $143,000 to customer lists if you think claiming a loss might raise an IRS eyebrow, but that is probably not necessary.

The 3.8% surtax on investment income should not apply to your gains. This is so because the assets sold were business assets rather than investment.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

Where to Report Sale of Goodwill on 4797

Source: https://www.abqjournal.com/2383874/tax-status-of-goodwill-sale-a-complex-question.html

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