If you are buying or selling 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 article 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).
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 tax pro before finalizing any transaction.
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.
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