Tax Issues When SELLING a Business With an Earnout

When a business is sold or purchased, the transaction might involve an earnout provision. This is a contractual arrangement in which the seller receives additional payment in the future if certain financial goals are met. In other words, a portion of the price is contingent on the performance of the company after the sale.

Naturally, an earnout arrangement has important tax implications for both the seller and the buyer. This article focuses on the seller side of the equation.

In general, when you sell a business asset or stock for a gain with an earnout, you must report it as an installment sale, unless you choose to "elect out" of that type of treatment. When the installment sale rules apply, which is usually the case, the federal income tax regulations set up three different scenarios, each with different tax implications, for the seller. Here is a brief explanation of each one, followed by explanations and strategies for minimizing taxes:

First Scenario: Maximum Sale Price Can be Determined

In this case, the maximum amount of sales proceeds that the seller can receive under the agreement is fixed. At the end of the year in which the business sale takes place, the earnout transaction is generally treated for federal income tax purposes as if the seller will receive the maximum possible payments at the earliest possible times.

Using this assumption, the seller's installment sale gain and gross profit percentage are calculated. Then, part of each contingent payment is treated as tax-free recovery of the seller's basis in the asset or stock, and the remainder of each payment is treated as taxable gain. If something happens that reduces the maximum possible sale price, the remaining price is refigured, and a new gross profit percentage is calculated for the remaining payments. What if the remaining maximum possible sale price is less than the seller's unrecovered basis? The seller is allowed to claim a bad debt deduction for the difference at the time the remaining installment receivable becomes worthless. (Source: IRS Regulation 15a.453-1(c)(2))

Key Point: The rules in the first scenario are often unfavorable to the seller because they can accelerate the timing of taxable gains to a point that seems unfair. These rules can even be a deal breaker. In some cases, it might be necessary to negotiate a new agreement that does not include a maximum stated sale price (as described in the scenarios below) in order to achieve acceptable tax results for the seller.

Second Scenario: Fixed Payment Period but No Maximum Sale Price

When an earnout deal involves payments that extend over a fixed period of time but does not stipulate a maximum possible sale price, another set of tax rules applies. Here is a brief summary of the rules — assuming the seller uses the installment method of reporting:

Key Point: The tax results under the rules for this scenario are often more acceptable to the seller than the results under the first scenario.

Third Scenario: No Maximum Sale Price and No Fixed Payment Period Either

Yet another set of tax rules applies when an earnout provision does not specify either a maximum possible sale price or a fixed payment period. In this scenario, the seller and buyer must first determine if a sale has actually occurred or whether the payments made by the buyer actually represent something else — such as royalties or rentals. Assuming that a sale has, in fact, occurred, the seller's basis in the asset or stock that is being sold is generally recovered in equal annual increments over 15 years. The seller receives the basis portion of each contingent payment tax-free. The remainder of each payment is taxable gain. (Source: IRS Regulation 15a.453-1(c)(4))

Key Point: Depending on what the seller believes about the amount and timing of future earnout payments and how accurate those beliefs turn out to be, the tax results in the third scenario could turn out better or worse than the results in the second scenario. For example, if the seller correctly anticipates that earnout payments will actually last for only seven years, the tax results would usually be worse for the seller. In such a case, the seller may want to negotiate a new agreement that stipulates a maximum payment period of seven years (such as in the second scenario), even though doing so could put a lower ceiling on the contingent payments.

Conclusion: The tax implications of selling a business with an earnout arrangement can be complex and sometimes unfavorable. What we have explained in this article are the general rules for sellers, but you may qualify for a more taxpayer-friendly exception. To lock in the best tax results, consult with your tax adviser before finalizing any earnout transaction.

Tax Issues When BUYING a Business With an Earnout

If you are buying a business, the transaction may involve an earnout provision. This is a contractual arrangement in which the seller receives additional payment in the future if certain financial goals are met. In other words, part of the price is contingent on the performance of the company after the sale.

Naturally, earnout arrangements have important tax implications for both the buyer and seller. This section focuses on the buyer side of the equation.

When you engage in a transaction with an earnout provision, the tax rules for contingent payments come into play. A contingent payment purchase is one in which business assets or the stock that you are buying cannot be determined with certainty by the end of the tax year when the purchase takes place.

Whether you buy the assets of the target business or its stock, you receive no tax basis from contingent payment amounts until they become fixed. In addition, you may actually have to make payment in cash to become entitled to basis under the so-called economic performance rules.

At the time contingent payments are taken into account by the buyer for tax purposes, part of each payment generally must be treated as interest, which can usually be deducted currently on the buyer's federal income tax return. If the terms of your earnout deal don't charge an interest rate the IRS considers adequate (meaning the stated rate is too low or zero), the imputed interest rules may come into play. If so, complex calculations must be made to determine how much of each payment is treated as interest and how much is treated as principal.

The amount of each contingent payment that is treated as principal generally creates additional tax basis in the acquired assets or stock. Therefore, your tax basis gradually goes up as contingent payments are made. When the tax rules treat the transaction as an asset purchase, this "rolling" approach makes it more complicated to calculate depreciation and amortization deductions for the acquired assets. To make matters more complicated, when the so-called residual method rules apply to a transaction treated as an asset purchase (under Section 1060 of the Tax Code), the increased basis amounts from contingent payments are often allocated to intangible assets that must be amortized over 15 years (called Section 197 intangibles).

Two Other Important Tax Considerations

  1. In an asset purchase deal, how the purchase price is allocated to the assets being bought and sold can be crucial for both buyer and seller. As the buyer, you probably want to allocate as much of the price as possible to short-lived assets such as inventory and receivables. In contrast, the seller will typically want to allocate as much as possible to low-taxed capital gain assets such as land, buildings and intangibles.
  2. You should carefully consider whether you want to use an existing legal entity or a new entity to acquire the target assets or stock. This issue can involve both legal liability concerns and tax considerations.

Depending on the circumstances, you may be able to treat an earnout transaction that's legally considered a stock purchase under applicable state law as an asset purchase for federal income tax purposes. (The entire transaction, including the earnout, is treated this way.) This is often advantageous for the buyer but unfavorable for the seller.

Conclusion: The tax (and legal) implications of buying a business under an earnout arrangement can be complicated. The terms of the earnout deal may involve better or worse tax consequences for you and the seller. Competing tax goals may lead to some necessary give and take on both sides. In many cases, the tax outcome can be healthier for you, depending on how the transaction is structured. To lock in the best results, consult with your Porte Brown tax pro before finalizing any transaction.

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