The Wall Street Journal prime interest rate is currently 8.5 percent, easily doubling potential interest expenses from a couple of years ago and preventing some business owners and entrepreneurs from even considering an acquisition.
That concern manifests at an inopportune moment as more than 70 percent of business owners aged 50 or older plan to exit their business within the next 10 years, according to the Exit Planning Institute.
Over the next decade, innovative and ambitious entrepreneurs will have numerous acquisition opportunities. IRS Code Section 197 can make those deals more affordable than you might expect by improving your profit margins and increasing cash flow through noncash deductions against income.
Tax deductions for business acquisitions
Buying an existing business is common; thousands of companies are bought and sold each year. Some buyers aim to expand their current business, while others are entrepreneurs who find an opportunity to buy into an established business and prefer to avoid the risks associated with a startup.
It’s widely known that the new owner of a business can deduct some of the costs, thus reducing their tax liability. For example, training, travel, and research before an acquisition can be expensed immediately. The cost of plant, property, and equipment can be depreciated over an extended period. A lesser-known opportunity for the buyer is to utilize Section 197 to amortize intangible assets.
The amortization of intangible assets is related to the accounting concept of depreciating hard assets. To reduce tax liability, acquirers list amortization as a noncash expense on their income statement. Intangible assets that can be amortized include going concern value, the workforce in place, client lists, operating procedures, patents, permits, noncompetition agreements, and market share. Loosely speaking, those intangible assets contribute to what is called “goodwill” and are amortized over 15 years.
What is and isn’t ‘goodwill’ in a business sale?
About 70 percent of small businesses listed to sell fail to do so, according to Teamshares. That should come as no surprise, given the often contentious back-and-forth over acquisition terms.
For example, the seller sometimes remains stubborn on a sale price that they inflate because of what they incorrectly call “goodwill.” It is not uncommon for the selling owner to expect a payout greater than fair market value because of their emotional connection to the time and effort they put into building the company.
However, when it comes to accounting, “goodwill” is an intangible asset that is only recorded when one company acquires another. Goodwill is the paid-for value of the company in excess of the fair market value of its hard assets. The so-called “sweat equity” from the owner is not a consideration.
Intangible assets cannot be expensed by the company that developed the goodwill. Goodwill can only be recognized as an amortizable intangible asset when ownership of a business is exchanged. For example, take Sheila’s company, which became one of the largest insurance companies in the Burlington, Vt. area when she purchased a competing firm from Ric.
How goodwill made Sheila’s acquisition affordable
Sheila bought Ric’s real estate separately and arranged the business transaction as an asset sale instead of a stock sale. In the “asset sale,” Ric maintained ownership of his legal entity, and Sheila instead bought physical assets and the client list and records. (A “stock sale” is a direct exchange of shareholder stock.)
The $4 million cost of Ric’s business included about $1 million worth of company cars, computers, and office supplies. As many people understand, Sheila could then take a noncash depreciation expense of those physical assets over an IRS-defined recovery period. The immediately expensed costs were relatively small, which made it challenging for many other potential buyers to afford the loan payments. However, Sheila had a tax-saving trick up her sleeve.
Sheila knew she could make this acquisition work because, under Section 197, she can take a noncash amortization deduction against the $3 million cost attributed to the client list and other intangible assets. Section 197 allows for amortization to begin either at the time of acquisition or the date associated business activity begins (in many cases, that means immediately).
Sheila was able to reduce her taxable income amount by $200,000 per year, making up for the interest expense from the loan she took to make the acquisition.
Acquisitions can effectively accelerate growth, take market share away from competitors, and improve profitability due to economies of scale. However, in this high-interest-rate environment, many would-be buyers ignore acquisition opportunities due to the increased debt burden. With a better understanding of how Section 197 of the IRS code can reduce taxes, your next acquisition may be more affordable than you thought.
This article first appeared in the Berkshire Eagle on February 17, 2024.