5 FAQs About the Tax Consequences of Earnouts

What is an Earnout and How Does It Impact a Business Seller’s Tax Liability?

An earnout is a financial arrangement in the sale of a business where part of the purchase price is deferred and contingent upon the future performance of the business. An earnout allows the buyer and seller to tie a portion of the payment for the business to the ongoing success of the business post-acquisition. This provides a level of security for the buyer against overpayment for unmet performance expectations and permits the seller to reap the rewards of the future success of the business.

An earnout can significantly impact the seller’s tax liability. The timing and nature of earnout payments determine how they are taxed. If an earnout is structured to qualify for installment sale treatment, the seller can defer recognizing taxable income until payments are received. Installment sale treatment allows for better matching of proceeds from the sale with the timing of tax payments. In addition, due to graduated tax rates, spreading the tax burden over several years could lead to lower overall tax.

However, if earnout payments are classified as compensation for services, the earnout payments will be taxed as ordinary income at higher tax rates. The key for sellers is understanding how different earnout structures can influence their tax outcomes and planning accordingly to optimize their tax position.

How Are Earnouts Taxed Differently in an Asset Sale vs an Equity Sale?

The taxation of earnouts in a business sale varies significantly between asset sales and equity sales, primarily due to the nature of what is being sold. To understand how the taxation of asset sales and equity sales differs in general, see Asset Sale vs. Equity Sale: Key Considerations When Selling Your Business.

In an asset sale, the earnout is typically applied to specific assets or a group of assets being sold. The tax treatment of each earnout payment depends on the type of asset it’s attributed to. For example, payments allocated to tangible assets such as machinery and equipment are taxed differently than those allocated to intangible assets like goodwill. The allocation affects whether the payments are taxed at ordinary income tax rates or capital gains tax rates.

On the other hand, in an equity sale, where the seller is transferring shares or interests in the company, the earnout payments are generally additional proceeds for the equity interests, whether it’s stock in a corporation or interests in an LLC. This means that the payments are more likely to be taxed as capital gains tax rates. Capital gains tax rates are lower than ordinary income tax rates for most sellers. The key factor is the characterization of the payment: whether it’s considered an additional payment for the equity (favoring capital gains treatment) or as something else, like compensation (which would be taxed as ordinary income).

In both asset and equity sales, the timing of the earnout payments can impact the tax outcome. Earnout payments could push up the seller’s marginal tax rate each year, depending on the seller’s total income in the year of receipt, and the graduated tax rates applicable in each year. Sellers can negotiate lower after-tax consequences of the sale of their business by carefully modeling the earnout payments.

Overall, understanding the nuances of how earnouts are taxed in asset sales versus equity sales is essential for business sellers. It allows them to structure their deals in a way that minimizes their tax liability and aligns with their financial goals. Sellers are advised to work closely with tax professionals who can guide them through these complex considerations and help optimize their tax outcomes based on the specific structure of their sale.

What are some Examples of How Sellers Can Structure Earnouts to Lower Taxes?

There are several ways sellers can structure earnouts to potentially lower their tax burden:

Capital Gains Treatment: Aim for an earnout structure that qualifies for capital gains treatment rather than ordinary income. This might involve structuring the earnout as part of the purchase price for the business, instead of as compensation or a bonus, which are typically taxed as ordinary income.

Installment Sale Method: Utilize the installment sale method for reporting the earnout. This installment method allows sellers to spread the recognition of income over the period in which the earnout payments are received, potentially reducing the overall tax rate each year as opposed to recognizing all the income in the year of sale. Paradoxically, if income tax rates are going to increase, it may be beneficial to elect out of the installment method of reporting the earnout payments.

Escrow Arrangement: Consider setting up an earnout that is placed in an escrow account with specific, objective milestones for release. This can provide more predictability in income recognition and may offer opportunities for tax planning around the timing of income receipt.

Deferral Strategies: If possible, structure the earnout to defer payments to future tax years where the seller anticipates being in a lower tax bracket. This can be particularly effective for sellers who are planning to retire or reduce their taxable income in future years.

Contingency Clarity: Clearly define the contingencies and performance metrics that trigger earnout payments. This can help ensure the payments are treated as part of the sale price (eligible for capital gains treatment) rather than as variable compensation (taxed at ordinary income tax rates).

Charitable Remainder Trusts (CRTs): In some cases, sellers can use CRTs to receive earnout payments. This allows deferring or spreading out the tax liability and can be particularly beneficial for sellers with philanthropic goals.

Each of these strategies has its nuances and legal considerations, and the effectiveness of each can vary depending on individual circumstances. It’s crucial for sellers to consult with their tax advisors to tailor these strategies to their specific situations and ensure compliance with tax laws and regulations.

In an Asset Sale, What Determines Which Payments Will be Taxed at Long-term Capital Gains Tax Rates versus Ordinary Income Tax Rates?

In an asset sale, the classification of earnout payments as long-term capital gains or ordinary income largely depends on how these payments are allocated to the various assets sold. This allocation, called the purchase price allocation, should be clearly outlined in the sale agreement. To understand more about the importance of the purchase price allocation in determining the seller’s after-tax proceeds, see Purchase Price Allocation: How It Affects Your Taxes When Selling Your Business.

Allocation to Capital Assets: Payments attributed to capital assets (like real estate) are typically eligible for long-term capital gains tax rates, provided they’ve been held for more than a year. These rates are generally lower than ordinary income tax rates.

Allocation to Intangible Assets: Payments allocated to intangible assets, such as goodwill, are also often taxed at long-term capital gains rates, assuming the holding period requirement is met.

Allocation to Depreciable Property Used in the Business: Payments allocated to depreciable property such as machinery or equipment are taxed at ordinary income tax rates to the extent of prior tax depreciation. This is called depreciation recapture. Depreciation recapture is more significant since 2017 because of bonus depreciation, which permitted most business property to be fully written off for federal income tax purposes. If the proceeds allocated to depreciable property exceed the property’s original cost, then in most cases those proceeds are taxed at long-term capital gain tax rates. If the depreciable property is real estate, then a different type of depreciation recapture could apply.

Allocation to Inventory or Receivables: If earnout payments are allocated to assets like inventory or accounts receivable, then any resulting gain or loss is usually taxed as ordinary income or loss. For service type businesses that use the cash method of accounting, accounts receivable will have no tax basis, making the fair market value of all accounts receivable taxable at ordinary income tax rates.

Seller’s Holding Period: The holding period of certain assets being sold is a crucial factor. Capital assets held for more than one year before the sale typically qualify for long-term capital gains treatment.

Nature of Contingency: The specific terms and conditions tied to the earnout can also impact tax treatment. For instance, if payments are contingent upon future services by the seller, they might be taxed as ordinary income.

Given these complexities, sellers should work closely with M&A tax professionals to strategically allocate earnout payments among the assets sold, aiming to maximize the proportion eligible for lower long-term capital gains tax rates.

What Role Does the IRS Play in Overseeing the Tax Treatment of Earnouts?

It’s essential that sellers follow IRS guidelines and income tax reporting requirements to secure the desired tax treatment of earnouts in business sale transactions. The IRS requires the purchase price allocation discussed above to be reported by both the buyer and seller on Form 8594, the Asset Acquisition Statement under Section 1060. This form reports the purchase price allocation and other details about the transaction, such as noncompete agreements and consulting arrangements.

The categorization of the assets sold on Form 8594 is the basis for which proceeds lead to gains taxed at ordinary income tax rates versus capital gains tax rates.

If the buyer and seller fail to agree on the purchase price allocation, or if they report differing allocations on their respective Forms 8594, this discrepancy can raise red flags with the IRS, potentially triggering an audit. It’s essential for both parties to agree on a purchase price allocation methodology before finalizing the transaction. This not only ensures compliance with IRS regulations but also helps both parties understand and prepare for the tax implications of the sale.

Conclusion

Understanding the tax implications of earnouts in business sales is crucial for sellers to optimize their after-tax proceeds. Through strategic structuring of earnouts, meticulous planning, and adherence to IRS guidelines, sellers can significantly reduce their tax liabilities. It is essential for sellers to work with a qualified tax advisor who can guide them in structuring earnouts.