The excess earnings method values a business by separating its normalized annual earnings into two parts: a fair return on the tangible assets, and everything above that, which is attributed to goodwill. You capitalize the excess portion to convert it into a lump-sum intangible value, add it to the tangible asset value, and the total is your business valuation. Revenue Ruling 68-609 is the governing authority, and it treats this formula as a fallback to use only when better evidence of intangible value is unavailable.1Internal Revenue Service. Valuation of Assets
The Formula, Step by Step
Five steps carry you from the balance sheet to a final number.
- Restate the company’s tangible assets — equipment, inventory, real estate, receivables — from depreciated book value to current fair market value.
- Multiply that tangible asset value by a reasonable rate of return, typically 8 to 10 percent under the ruling’s guidance. This is what an investor could expect to earn from the hard assets alone.
- Subtract that expected return from normalized annual earnings. The remainder is the “excess earnings” — the income attributable to intangibles like reputation, customer relationships, and brand.
- Divide the excess earnings by a capitalization rate, typically 15 to 20 percent, to convert them into a lump-sum intangible value.
- Add the tangible asset value and the intangible value together for the total business value.
A Worked Example
Say a company has $400,000 in tangible assets at fair market value and $90,000 in normalized annual earnings. A 10 percent return on the tangible assets is $40,000. Subtract that from $90,000 and you get $50,000 in excess earnings. Capitalize that at 20 percent ($50,000 ÷ 0.20) and the intangible value is $250,000. Add it to the tangible base and the business is worth $650,000.
Now watch what happens when you shift a single rate. Drop the capitalization rate from 20 percent to 15 percent and the intangible value climbs to roughly $333,000, adding $83,000 to the total. That sensitivity is the method’s biggest practical weakness, and it is why appraisers spend more time defending their rate selections than any other part of the calculation.
Normalize Earnings Before You Run the Formula
Raw financial statements rarely reflect what a business actually earns in a typical year. Before applying the formula, adjustments strip out distortions. Most practitioners average at least five years of data to smooth out year-to-year swings, which aligns with IRS preferences.
One-time items go first. Lawsuit settlements, insurance recoveries, and disaster-related repair costs get removed because they will not recur under normal operations. Owner compensation is the next target. Closely held owners often pay themselves well above or below market rate for tax planning reasons, so the appraiser substitutes what a non-owner manager would earn in a comparable role. The IRS recommends benchmarking that figure against general industry surveys organized by SIC or NAICS code, industry-specific salary data from trade organizations, and proxy statements from publicly traded companies.2Internal Revenue Service. Reasonable Compensation Job Aid for IRS Valuation Professionals
Non-operating assets also need attention. Personal vehicles, vacation properties, and investment accounts held inside the business entity do not contribute to operating income, so they get excluded from the tangible asset base and any related income is stripped from earnings. Only after these adjustments are the tangible assets themselves restated from historical cost to current fair market value.
Choosing the Rates
Revenue Ruling 68-609 suggests 8 to 10 percent as the return on tangible assets and 15 to 20 percent as the capitalization rate for excess earnings. The ranges look narrow, but the example above shows how much a small move can shift the outcome.
The tangible asset rate is lower because physical assets carry less risk. Equipment and inventory can be sold, financed, or repurposed. A business with high-quality, liquid assets like commercial real estate might warrant a rate at the lower end. One with aging specialized machinery and perishable inventory pushes toward the upper boundary.
The capitalization rate for excess earnings is higher because goodwill is fragile. Customer loyalty can evaporate, a key employee can leave, a competitor can undercut pricing. The more the business depends on a single person or a small number of clients, the higher the capitalization rate should be. The ruling says the rates should reflect “the percentage prevailing in the industry involved at the date of valuation,” which gives practitioners flexibility and leaves plenty of room for disputes.
When You Shouldn’t Use It
Revenue Ruling 68-609 expressly states the formula should not be used if better evidence of intangible value is available. The IRS treats it as a fallback. When comparable sales data, discounted cash flow analyses, or other market-based methods can credibly estimate intangible value, those approaches take priority. Reaching for the excess earnings method without first explaining why other methods fail invites scrutiny from both the IRS and opposing counsel.
The deeper criticism, which the IRS itself has voiced, is that the method assumes tangible and intangible assets each earn separate, independent streams of income. In reality a business generates revenue through the combined use of all its assets. A restaurant’s stove does not earn income on its own, and neither does its reputation. Treating them as if each produces its own return is a convenient fiction. No published data source reliably tracks what buyers and sellers actually earn as a rate of return on tangible versus intangible assets across industries, and the IRS’s own 1978 Appellate Conferee Valuation Training Program stated that the rates used in the formula “are arbitrary and have no foundational basis.”
The method persists because it is simple and because the ruling is still on the books. Courts continue to accept it, particularly in divorce proceedings and estate tax disputes where more sophisticated methods may not be feasible. But the apparent precision of the calculation disguises a significant amount of professional judgment baked into the rate choices, and a valuation report should say so.
Goodwill, Sale Structure, and Taxes
The goodwill number the formula produces has real tax consequences once the business changes hands, and those consequences depend on how the deal is structured and who owns the goodwill.
Personal Versus Enterprise Goodwill
Not all goodwill belongs to the business entity. Enterprise goodwill stays with the company regardless of who owns it. Personal goodwill walks out the door with the owner. The distinction matters most in C corporation sales, where allocating value to personal goodwill can avoid a layer of corporate-level tax.
The Tax Court drew the clearest line in Martin Ice Cream Co. v. Commissioner, holding that a shareholder-employee’s personal relationships are not corporate assets when the employee has no employment contract or noncompete agreement with the corporation.3Bradford Tax Institute. Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 Two conditions generally need to exist for goodwill to qualify as personal: the value must depend on the individual’s reputation, relationships, or specialized knowledge rather than on systems or brand the company built independently, and the individual must never have transferred that goodwill to the corporation through an employment or noncompete agreement. When a seller can credibly allocate a portion of the purchase price to personal goodwill, that amount is taxed as long-term capital gain to the individual rather than flowing through the corporate-level tax first. The IRS scrutinizes these allocations closely.
Section 197 Amortization and Deal Structure
When a buyer acquires goodwill in an asset purchase, it becomes a “section 197 intangible” that must be amortized ratably over 15 years.4Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles The same 15-year period applies to customer lists, covenants not to compete, trademarks, and workforce-in-place agreements.5Internal Revenue Service. Intangibles
In a standard stock purchase, the buyer gets no step-up in the tax basis of the company’s assets. The historical basis carries over and there is nothing new to amortize. That is why buyers often push for an asset deal or, when a stock purchase makes more sense for other reasons, negotiate a Section 338(h)(10) election that treats the transaction as an asset purchase for tax purposes. The structure of the deal often determines whether the goodwill value calculated under the excess earnings method produces any tax benefit for the buyer.
Reporting on Form 8594
Both buyer and seller in an asset acquisition must file Form 8594 with their income tax returns for the year of the sale whenever goodwill or going concern value attaches to the transferred assets.6Internal Revenue Service. Instructions for Form 8594 – Asset Acquisition Statement Under Section 1060 The purchase price gets allocated across seven asset classes using the residual method in Section 1060.7Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions Goodwill and going concern value sit in Class VII, the last class to receive any allocation, meaning consideration flows to goodwill only after all other asset classes are satisfied. If the buyer and seller agree in writing on how to allocate the purchase price, that agreement binds both parties unless the IRS determines the allocation is inappropriate. Disagreements between buyer and seller on Form 8594 are a common audit trigger.
Penalty Risk for Aggressive Valuations
An inaccurate business valuation can cost more than the underlying tax. Under Section 6662, the IRS imposes a 20 percent penalty on any underpayment attributable to a substantial valuation misstatement, defined as claiming a value that is 150 percent or more of the correct amount. If the misstatement is gross, meaning the claimed value is 200 percent or more of the correct amount, the penalty doubles to 40 percent of the underpayment.8Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
These penalties reach estate and gift tax valuations, charitable contribution deductions, and purchase price allocations in business acquisitions. Because the excess earnings method is already vulnerable to criticism over its subjective rate selections, a valuation that is both methodologically weak and numerically aggressive is a costly combination in an audit. The best protection is a well-documented appraisal that explains the rate choices, addresses why alternative methods were not used, and demonstrates that the normalized earnings reflect actual business performance rather than cherry-picked data.