Merger and acquisition (M&A) activity is widely expected to pick up this year, after a lull in 2022. Amid economic uncertainty, earnouts are likely to play a big role in many deals. The structuring of such transactions could have significant tax implications that affect the ultimate value for both parties.
The Basics
Earnout provisions generally arise when buyers and sellers have markedly different views on the value of the target business. Today, the gap between what sellers want to receive and what buyers are willing to pay may have widened because many variables underlying business valuations — namely, expected cash flows, pricing multiples and rates of return — have become less certain in the current rocky economy.
Earnouts can help bridge the valuation gap and facilitate deal making. Typically, earnout clauses provide that the buyer will pay the seller an additional amount only if the business achieves specific financial or operational metrics by an agreed-upon date after the closing. For example, 10% of the purchase price might be contingent on whether an acquired company meets a specific revenue or earnings target over a two-year period.
Dueling Tax Treatments
Depending on how a deal is structured, earnout payments may be treated as either:
- Part of the purchase price, or
- Compensation to the seller for services rendered.
If an earnout is deemed part of the purchase price, it’s taxed at the capital gains rate, generally 15% or 20%. The 3.8% net investment income tax also may apply in this situation.
However, if an earnout is considered compensation, it’s taxed at the applicable ordinary income rate, which can be as high as 37%. Plus, it’ll be subject to payroll taxes.
The characterization of an earnout affects the buyer, too. An earnout that’s treated as compensation is immediately deductible. On the other hand, the earnout must be capitalized and amortized over time if it’s considered a deferred payment on the purchase price.
Important: An earnout that’s considered compensation also could be subject to the so-called “golden parachute” limit on deductions and the deferred compensation rules.
Timing Issues
How an earnout is characterized also controls the timing of the seller’s tax obligation on the transaction. If an earnout is compensation, the seller must pay all taxes on a deal in the year of the sale.
However, if the earnout is part of the purchase price, the seller can defer part of its tax liability under the installment sale method. In this case, the tax timing varies depending on whether the maximum possible purchase price and the earnout period can be determined.
Under the installment method, a seller recognizes capital gains on each payment according to the ratio of the gross profit on the sale to the purchase price. For example, if the profit (or capital gain) on a $30 million sale is $25 million, the gross profit percentage is 83% ($25 million divided by $30 million). That means the seller would recognize 83% of gain on each installment. The remainder (17% of each installment) represents the owner’s basis in the business and isn’t recognized as income. The issue when an earnout is involved is that the final sale price will depend on whether the company achieves the benchmarks outlined in the earnout provision, triggering earnout payments.
When the maximum possible price can be determined, the seller generally is treated as if it will receive the maximum possible earnout payment at the earliest possible time. In other words, the maximum possible purchase price is used to calculate the gross profit percentage. This can accelerate the timing of the taxable gains for the seller.
In cases where the maximum possible price can’t be determined but the period over which an earnout might be paid is fixed, the seller’s capital gain is allocated in equal annual increments to each tax year in the fixed period. This approach typically is better for a seller than the previous scenario.
In situations where neither the maximum possible price nor the earnout payment period is determinable, the seller’s capital gain is recognized in annual increments over 15 years.
Compensation vs. Purchase Price
Several factors can indicate whether an earnout is part of the purchase price or compensation for the seller’s services, including:
- Whether the seller is required to perform services to receive the earnout payment,
- Whether the seller is receiving separate reasonable compensation for those services,
- Whether the seller’s employment is required for the entire earnout period,
- Whether the earnout is paid even if the seller is terminated, and
- How the earnout amount compares with reasonable compensation for the seller’s services.
Another important consideration is whether there’s any evidence of intent in documentation related to the transaction. For example, does correspondence show a difference of opinion on the target’s valuation and, in turn, the purchase price — and then the deal closed after an earnout was added? Does the letter of intent connect the earnout to the seller’s continued employment?
Do Your Due Diligence: Whether buying or selling a business, always consult with your tax advisors to ensure the transaction documents and structure reflect the intended tax results. Otherwise, you could end up reaping less than expected.
