Personal vs. Business Goodwill

“An ounce of prevention is worth a pound of cure.”

Goodwill Allocation – the issues.

In today’s active M&A market, one issue acquiring companies should carefully consider is the proper and efficient allocation of goodwill associated with the purchase of any business. How goodwill is allocated, and how its value is determined, can have significant ramifications for both buyers and sellers. Besides the conflicting tax consequences between buyer and seller, the acquiring company now has to be concerned about the annual impairment test of goodwill. Therefore, it is important to address the purchase price allocation early in the financial analysis.

Five-Step (Goodwill) Allocation Method

For corporate acquisitions, the IRS has defined a five-step allocation method. This method allocates value to tangible assets and then identifiable intangible assets, such as trademarks or licenses, before the remaining amount, or residual, is allocated between “going-concern value” and goodwill. Because sellers prefer goodwill allocations [vs. going-concern value] in order to allocate transaction value outside of the business entity, and buyers are not affected by the allocation, the IRS’ scrutiny is generally high.

All remaining residual value is allocated to goodwill. The proportion of value allocated to business and personal goodwill depends on the specific facts and circumstances of each transaction. Both the nature of the business and the deal structure may impact the allocation. As businesses get larger and less dependent on the owners’ personal relationships and reputation, the allocation shifts from personal goodwill to business goodwill. A separate purchase agreement for personal goodwill, supported by a non-compete or employment/consulting agreement, can increase the value allocated to personal goodwill, further decreasing the business goodwill value. One advantage to booking a lower business goodwill value onto the balance sheet of an acquiring company, is the lower likelihood of having a FAS 142 goodwill impairment issue as the company moves into the future. Every year, the carrying value of goodwill must be compared to the fair market value of the operating unit to which the goodwill is allocated. Proper valuation and allocation at the time of the transaction can alleviate impairment issues later.

Goodwill Allocation Key Points

In corporate asset sales, taxes apply to the liquidation of any gains, so goodwill allocated to individuals reduces corporate taxes; In installments sales, any goodwill allocated to a shareholder can be deferred during the installments; In deemed asset sales there is no transaction fixing the purchase price and the IRS may have cause to dispute allocations; In C-to-S conversions, corporate goodwill at conversion increases potential future built-in gains (BIG) taxes; The value of goodwill booked by an acquiring company must be re-examined on an annual basis for impairment.

Conclusion

There are good reasons to consider an independent valuation of the goodwill that must be allocated in M&A transactions. Corporate tax savings can be achieved by shifting value allocations from business goodwill to personal goodwill. The classification of goodwill depends largely on the facts and circumstances of each case, and properly supporting the value allocations requires expertise in all business valuation methodologies. Knowledgeable, independent business appraisers understand the impact of these factors and can assist companies in determining the proper allocation.

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.
Daniel Kvarnberg

Valuation
dkvarnberg@pcecompanies.com
Orlando Area Office

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