The Earnout Equation: Tax Tips for Both Buyers and Sellers

Earnouts are a form of contingent consideration that the buyer of a business pays to the seller in the period following the acquisition, based on the business achieving various financial metrics related to its performance following the change in ownership. They are popular for many reasons. For instance, some buyers prefer an earnout instead of obtaining third party financing. In addition, if the parties cannot agree on the value of the business, an earnout is appropriate because it can adjust the purchase price based on the business’s future performance, the strongest indicator of value. Finally, if the target is a closely-held business that continues to employ the owner(s) following the sale, the seller has an incentive to make sure the business is off to a good start in the hands of the buyer. Given this range of possible motivations for structuring the consideration for an acquisition to include an earnout, however, it is not always clear when an earnout is treated as additional purchase price or compensation for services for tax purposes. This DE Insight discusses the factors that parties should consider and how to plan for the most certainty.

Tax Treatment of Earnouts: Deferred Purchase Price vs. Compensation for Services

The tax treatment of the parties to an earnout is markedly different depending on how they characterize it for tax purposes. If the parties agree to treat earnout payments as deferred purchase price, some or all of each payment (depending on whether the purchase agreement calls for adequate stated interest) will be added to the basis of the stock (in a stock purchase) or the assets (in an asset purchase), and will be subject to depreciation or amortization depending on the nature of the assets and their relative fair market values. The seller will have a return of basis and/or gains that are either subject to recapture as ordinary income or taxed as long-term capital gains.

On the other hand, buyers could receive a deduction for earnout payments treated as compensation, and that payment (which also may be subject to employment tax withholding) would be ordinary income to the recipient, even if made in the form of equity. The parties also need to consider whether Section 83 of the Internal Revenue Code of 1986, as amended (the “Code”), which provides rules applicable to property transferred in exchange for services, applies to grants of restricted stock that vest contingent on future employment or performance. Deferred payments of performance-based compensation also implicate Section 409A of the Code, which imposes significant consequences, including upfront taxation and penalties, to nonqualified deferred compensation arrangements that do not comply with, or are not exempt from, its strictures.

Relevant Case Law

Even if the parties agree in the purchase agreement to treat payments under an earnout as deferred adjustments to purchase price, however, there is always a risk that the Internal Revenue Service (“IRS”) will recharacterize some or all of the payment as compensation. In Arrowsmith v. Commissioner, 344 U.S. 6 (1952), the Supreme Court ruled that losses arising from the payment of a judgment against a corporation by its shareholders, who had treated prior year liquidating distributions from the corporation as giving rise to capital gains, were capital in nature because they arose from the shareholders’ liability as transferees of the corporation’s assets. The Court’s reasoning in Arrowsmith arguably allows parties to apply this “origin of the claim” theory to treat payments arising out of the sale of a business as adjustments to the purchase price.

In Lane Processing Trust v. U.S., 25 F.3d 662 (8^th Cir. 1994), however, the Court of Appeals held that payments to employees of several companies held in trust, who were beneficiaries of the trust, following the sale of the underlying stock, were wages where the payments were tied to the value of the services performed by the employee, the length of the employee’s employment, and the employee’s prior wages. In addition, only individuals who were employees at the time of distribution were entitled to payment. The IRS could therefore use the reasoning of Lane Processing Trust and its progeny to argue that payments styled by the parties to a transaction as additional purchase price are in fact wages, if those payments are contingent on a seller’s continuing service.

Planning Considerations

Many transactions, however, fall squarely in neither camp. Sellers of a business could receive both compensation for services to the business and payments based on the performance of the business that are not tied to continuing employment or individual performance. The best way to resolve this dilemma is to agree to pay amounts (whether wages, bonuses or fees for consulting services) to former owners continuing with the business that constitute reasonable compensation for tax purposes, as well as to structure earnout payments in line with the valuation of comparable businesses. In this way, the parties’ preferred treatment of payments to sellers following the sale of a business are more likely to be respected.

Conclusion

Earnouts are a common feature in mergers and acquisitions, serving as a form of contingent consideration paid by the buyer to the seller after closing, based on the business’s post-acquisition performance. They can help bridge valuation gaps, reduce the need for third-party financing, and incentivize sellers who remain involved in the business. The tax treatment of earnouts can vary significantly depending on whether they are characterized as additional purchase price or as compensation for services. Proper structuring is essential to ensure the intended tax consequences and to minimize the risk of IRS recharacterization.

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This DarrowEverett Insight should not be construed as legal advice or a legal opinion. This Insight is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concerning any particular situation and any specific legal question you may have. Please reach out to us if you need help addressing any of the issues discussed in this Insight, or any other issues or concerns you may have relating to your business. We are ready to help guide you through these challenging times.

This Insight does not constitute written tax advice as described in 31 C.F.R. §10, et seq. and is not intended or written by us to be used and/or relied on as written tax advice for any purpose including, without limitation, the marketing of any transaction addressed herein. Any U.S. federal tax advice rendered by DarrowEverett LLP shall be conspicuously labeled as such, shall include a discussion of all relevant facts and circumstances, as well as of any representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) upon which we rely, applicable to transactions discussed therein in compliance with 31 C.F.R. §10.37, shall relate the applicable law and authorities to the facts, and shall set forth any applicable limits on the use of such advice.