IT DEPENDS. If the goodwill asset is considered personal goodwill from one of the shareholders, the shareholder recognizes capital gain on the sale of the asset. For instance, if a shareholder sells a business in which his or her personal relationships with clients/customers are important to the purchaser, the personal relationships are considered personal goodwill and will be taxed as capital gain to the shareholder.
If the shareholder sells the personal goodwill to the s-corporation and in return gets paid in the future for services provided to the s-corporation as a result of the goodwill, then those earnings will be ordinary income to the shareholder. For example, if the only shareholder in an s-corporation sells the personal goodwill listed above and agrees to be a shareholder/owner at the business acquiring the goodwill, the income earned by the selling shareholder at the new business will be taxed as ordinary income to the selling shareholder.
Lastly, if the business created the goodwill, such as a license, a customer list, brand name, etc, the asset will be considered a capital asset and will be subject to capital gains tax to the s-corporation. The asset will have zero basis if it is self-created. Please read the following article found in the Tax Adviser Journal. https://www.thetaxadviser.com/issues/2014/may/payne-may2014.html
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The IRS will consider this self-employed income and it should be reported on an IRS Schedule C. Your grandson can also deduct a number of expenses he incurred in this line of work. The Schedule C information / numbers will flow onto the main tax reporting form - the IRS 1040.
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With so many complex issues to consider, a section
338(h)(10) election can be a complex transaction that may
not be appropriate for all S corporation sellers or buyers. A section 338(h)(10) election will adjust the
tax basis of the S corporation’s assets in the hands of
the buyer to fair market value. As an alternative in this type
of transaction, the portion of an S corporation’s asset
value that can be attributed to the “personal goodwill”
of the company’s owners or executives is allocated and
segregated from the total asset value. The proceeds of
that goodwill are reported as a gain to the shareholder
to whom the goodwill relates and are treated as
long-term capital gains. For S corporations with
built-in gains, shifting purchase price to a shareholder’s
personal goodwill may limit the double taxation that
results from the built-in gains tax. The buyer benefits
because it can deduct the purchase price associated
with personal goodwill over 15 years The sale may completed pursuant to installment sale rules, which involves disposition of property at a gain, where at least one payment is to be received after the tax year in which the sale occurs. This option offers the advantage to the seller of receiving payments over time and only including in income each year the part of the gain received that year. For more information, please refer to IRS Publication 544 - "Sales and Other Dispositions of Assets" at the following link: https://www.irs.gov/publications/p544
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