When the assets comprising a whole trade or business are sold, the purchase price of the trade or business is to be allocated among all tangible and intangible assets of the business in accordance with the terms of Internal Revenue Code (IRC) Section 1060. Gain or loss is then determined on an asset-by-asset basis by comparing the difference between the amount of consideration allocated to each asset and the asset’s adjusted basis. The characterization of the gain or loss realized and recognized on the disposition of an intangible asset will depend on the type of asset involved and the manner in which it was created. Gains from self-created goodwill and going concern value—known as “Class VII” assets under IRC §1060—commonly arise and are reported on federal Form 8594. These gains represent the amount of the purchase price paid more than and above the fair market value of all the assets sold and are typically taxed at the capital gains rate. After the amount of the gain is determined, no further analysis is needed for federal income tax purposes. However, for state income tax purposes, the manner in which these gains are apportioned or allocated is anything but clear.
Nonetheless, the allocation or apportionment outcome prescribed by a given state generally can fall into one of three categories:
Category 1: A handful of states continue to apply only the transactional test for making the apportionable business versus allocable nonbusiness income distinction (as opposed to both the transactional and functional tests, which would likely render the gain apportionable business income). If the state continues to only apply the “transactional” test, the state will typically allocate the entire goodwill and going concern gain to the commercial domicile of the seller.
Category 2: While many states consider the gain from goodwill and going concern value apportionable business income, several such states entirely exclude the goodwill and going concern value gains from the seller’s sales factor to avoid a distortive result. The exclusion from the sales factor may still lead to a distortive result. The seller may wish to consider invoking alternative apportionment depending on the facts and circumstances to achieve a more equitable result.
Category 3: Some states will consider the gain from goodwill apportionable business income and include the gain in the sales factor. The state(s) to which the goodwill and going concern gain is actually sourced will vary. Some states may apportion the entire amount to the seller’s commercial domicile or the seller’s market, i.e., in the same proportion of the seller’s existing sales factor, or use another methodology. The seller may wish to consider invoking alternative apportionment depending on the facts and circumstances to achieve a more equitable result.
A careful state-by-state analysis is required to properly apportion or allocate gains from goodwill and going concern, as the amount of state income tax due on these gains can quickly become material.
For additional guidance on how to apportion and allocate gains from goodwill and going concern, contact your BKD Trusted Advisor™ or submit the Contact Us form below.