By Michael French, CPA

Earnouts and contingent payments are common features of business transactions, particularly in mergers and acquisitions. They allow buyers and sellers to bridge valuation gaps and align incentives, but also introduce complex tax considerations that must be carefully navigated.

Earnouts and Contingent Payments

Earnouts are contractual provisions in a business transaction that tie a portion of the purchase price to the future performance of the acquired business. Sellers receive additional payments if certain financial or operational milestones are met, and it is common for the seller to remain employed by the business for a certain period of time, typically two to three years, to ensure the benchmarks are met. Contingent payments, similarly, are payments that depend on future events, such as regulatory approvals or the achievement of specified revenue thresholds.

While these structures can benefit both parties, they introduce tax complexities that require careful planning. Moreover, the buyer and seller often have competing tax considerations, so a structure that benefits one will not help the other in certain circumstances.

Tax Treatment of Earnouts

The tax treatment of earnouts depends on several factors, including the structure of the transaction, the nature of the earnout payments and the classification of the seller.

• Installment sale treatment — Earnouts are often treated as installment sales for tax purposes. Under the installment method, sellers recognize gain as payments are received rather than at the time of the initial sale. This method can provide tax deferral benefits, but it also requires careful tracking of payments and basis allocation.
• Capital gains vs. ordinary income — The classification of earnout payments as capital gains or ordinary income is a critical tax consideration. If the earnout is considered part of the purchase price, it is generally taxed at capital gains rates, lower than ordinary income tax rates. However, if the earnout is tied to the seller's continued employment or services, it may be classified as compensation and taxed as ordinary income. The IRS considers several factors in determining whether an earnout is considered compensation or part of the purchase price. The factors that favor ordinary income tax treatment include whether the earnout is fully or partially conditioned on future services, and whether the seller's employment term is aligned with the earnout period. Factors that favor capital gains tax treatment include whether the seller's post-closing employment compensation is close to market, the proportionality of earnouts, and the buyer's earnout obligation if the seller's employment is terminated.
• Interest component — Earnout payments may include an interest component, particularly if they are deferred over multiple years. The IRS may require sellers to recognize a portion of the earnout as interest income, which is taxed at ordinary income rates.

Tax Considerations for Contingent Payments

Contingent payments introduce additional tax complexities, particularly in determining when and how they should be recognized.

• Open vs. closed transactions — Contingent payments can be treated as either open or closed transactions. In an open transaction, the seller does not recognize the gain until the contingent payment is received. In a closed transaction, the seller estimates the fair market value of the contingent payment at the time of the sale and recognizes the gain accordingly.
• Section 83 considerations — If contingent payments are tied to services performed by the seller, they may be subject to Section 83 of the Internal Revenue Code. This section governs the taxation of property received in exchange for services and may impact the timing and character of income recognition.
• Structuring considerations — Buyers and sellers must carefully structure contingent payments to optimize tax outcomes. Factors such as payment timing, valuation methodologies and contractual language can influence tax treatment and potential IRS scrutiny.

Planning Strategies for Sellers

Sellers can employ several strategies to optimize the tax treatment of earnouts and contingent payments:

• Negotiate for capital gains treatment — Structuring earnouts as part of the purchase price rather than compensation can result in lower tax rates.
• Consider installment sale benefits — Using the installment method can defer tax liabilities and improve cash flow.
• Account for interest components — Understanding the potential interest component of earnout payments can help sellers plan for tax obligations.
• Seek professional guidance — Given the complexity of tax rules, consulting with tax professionals can help sellers navigate potential pitfalls and optimize tax outcomes.

Planning Strategies for Buyers

Buyers also have tax considerations when structuring earnouts and contingent payments:

• Deductibility of payments — Buyers may prefer earnouts to be classified as compensation to secure tax deductions.
• Financial reporting implications — Earnouts can impact financial statements and tax reporting, requiring careful planning.
• IRS compliance — Ensuring that earnout structures comply with IRS regulations can prevent audits and disputes.

Summary

Earnouts and contingent payments are valuable tools in business transactions, but they require careful tax planning. Understanding the nuances of installment sales, capital gains treatment, interest components and contingent payment structures can help buyers and sellers optimize tax outcomes and avoid unexpected liabilities.

For more information or a discussion about how to address the tax treatment of earnouts and contingent payments in your business transaction, contact your PKF Advisory team member or:

Michael French, CPA, ABV, CFE
Managing Director
Tel: 949.860.9891
Email: mfrench@pkfadvisory.com