Tax Treatment of Earnouts

Tax Treatment of Earnouts
Kevin W. Kaiser
Buyers and sellers often do not agree on the value of
an acquisition target, making the structure and mix
any M&A transaction are the amount, timing and
of consideration a contentious issue. These different
character of the gain or loss on sale.
viewpoints are often resolved by tying a portion of
the purchase price to the future performance of the
Q: How are earnouts taken into account for tax?
acquired business. The variety of contingent purchase
A: Generally, an earnout should provide for deferred
price arrangements, or earnouts, are limited only by the
gain recognition by the seller. The tax laws commonly
creativity of the dealmakers.
provide for the recognition of the transaction in one of
three ways: (1) closed transaction—seller recognizes
Understanding and managing the tax treatment of
the gain or loss currently, regardless of whether the
earnouts can benefit both buyers and sellers. Below
earnout is achieved; (2) open transaction—seller
are some frequently asked questions relating to the tax
recognizes gain after basis in the property sold is
treatment of earnouts.
recovered; and (3) installment sale—seller recognizes
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the income over the periods during which earnout
Q: What are the primary tax considerations when payments are received. The method used to report the
structuring a deal to include an earnout?
transaction will govern the timing and amount of the
A: The threshold question is whether or not any portion
recognized gain or loss. It should also be noted that
of the potential earnout is taken into account by the
there may be situations in which a seller would choose
buyer and seller in the year of the sale. Depending
to recognize the sale of a business currently and forego
on the terms of the transaction, gain or loss may be
deferral treatment, such as when a business is sold at a
recognized in the year of the sale, or may be deferred in
loss, or when it is known or expected that tax rates will
whole or in part until earnout payments are received.
increase in the future.
Q: What other tax issues arise when structuring
Q: Are buyers and sellers free to choose which reporting
transactions with earnouts?
method they use?
A: Typically, the three elements that must be analyzed
A: No. The proper reporting method will be governed
and resolved to correctly plan and report the tax
by the terms of the earnout. Most sellers prefer either
treatment of
open transaction accounting or installment reporting.
These two methods defer gain recognition and generally
compete as ordinary income. An example of contingent
best match the receipt of cash with the gain recognition.
consideration in a compensation agreement would
Open transaction accounting is available only when the
be employer restricted stock. The former owner of a
receipt of the earnout is speculative and the ultimate
business may agree to perform services for the buyer
realization is highly uncertain. The installment reporting
in exchange for buyer-restricted stock that vests over a
rules allocate the gain recognition over the life of the
period of years (e.g., one-third vesting each year over
earnout. Certain earnout terms, such as maximum
three years) with forfeiture of any stock that remains
payout and payment period, will determine if and how
unvested upon termination of employment.
the installment reporting recognition rules will apply to
the transaction.
These types of compensatory arrangements often
result in the seller-employee recognizing compensation
Q: How are the recognized gains and losses
income (and the buyer-employer recognizing the
characterized for tax purposes?
corresponding deductible expense) when the
A: Generally, gains and losses are treated as arising
restrictions on the seller-employee lapse.
from a property transaction. Accordingly, sales of
stock held as a capital asset will obtain capital gain or
Q: Do the earnout tax rules also apply to nontaxable
loss treatment. In an asset deal, the sale of trade or
transactions?
business property will typically be subject to the special
A: Yes. The earnout rules also apply to nontaxable
rules providing for capital gains and ordinary losses. In
transactions. Nontaxable stock and asset deals can be
addition, depreciation recapture rules may cause certain
structured with contingent consideration. However,
gains recognized in asset deals to be characterized as
when the mix of consideration in a nontaxable
ordinary income. In the event that installment method
transaction (e.g., a merger) includes contingent
reporting is used, a portion of the recognized income
payments, additional tax issues arise and the complexity
may be characterized as interest income.
of the subject transaction increases.
Q: Do the earnout rules apply to post-closing seller
As the deal flow continues to gain strength, many advisors
services arrangements and noncompete covenants?
will be working with buyers and sellers using earnouts
A: Yes. These arrangements are common and will
to bridge the gap on valuation. Being aware of the tax
influence how the earnout tax accounting rules are
treatment of these arrangements and knowing how to
applied. If the seller’s right to receive some portion of
optimize it can inject additional value into a transaction.
the earnout is conditioned on the provision of services
or the agreement to a non-compete covenant, then
the seller may have to recognize the portion of the
consideration relating to the services or non-
Kevin W. Kaiser
Partner
612.371.2467
kkaiser@lindquist.com
lindquist.com/kkaiser
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