The Problem with Goodwill in 1031 Exchanges

Goodwill is not considered like kind property. This is because the goodwill of a business can never be exchanged for goodwill of another business. This is identified in the United States Treasury Regulations which state that the going concerned value or goodwill of a business is not of a like kind to the goodwill or going concerned value of another business. A recent case known as Deseret Management Corps. Vs Commissioner shows the fact that goodwill may exist and be recognized in addition to being mixed in with business assets transferred in an exchange under internal revenue code section 31.

The very existence of goodwill, therefore can create taxable boot. Whether goodwill exists or not is a question of circumstances and facts. But the very possible existence of goodwill cannot be ignored in a 1031 exchange. This concern comes down to the issue of expert valuation testimony in order to determine whether goodwill exists and the value that should be assigned to it. In the case mentioned above, a taxpayer exchanged assets of a radio station including a license for the FCC for the assets owned by another radio station.

The taxpayer followed all of the grouping rules for personal property but the Internal Revenue Service disputed whether goodwill was properly accounted for as well as what the value assigned to goodwill would be. This is because that goodwill could be treated as taxable boot.

Where the case headed from here had to do with a battle of the experts. Fortunately the credibility of the experts on the side of the taxpayer allowed the taxpayer to prevail. Only a small portion of the value attributable to the assets was found to be linked to goodwill, and therefore the court concluded that the amount of going concern or goodwill value in this case was negligible. So what can be learnt from this story? When exchanging business assets, you need to carefully consider whether there is an existence of going concern or goodwill value. In exchange that might otherwise be classified as meeting the qualifications for tax deferral may actually be taxable. So careful thought and evaluation is required. And finally, a qualified appraisal is essential for avoiding clashes and challenges down the road.