The tax treatment of the earnout to the seller requires sharp analysis. Is the earnout contingent upon the seller’s continued employment by the buyer? If so, is the earnout really additional purchase price (capital gain) or another way of providing incentive compensation (ordinary income)?
The timing of the recognition of gain on the sale is also affected by the earnout. The installment method of reporting the gain on the sale, in which the tax liability is deferred until cash is received, is allowed. But that gain will necessarily be accelerated, either because all contingent future payments of the earnout are included in the gain calculation or because the basis of the shares sold is allocated ratably over the earnout period.
If the operating results are not achieved so that additional earnout payments are not made, the capital loss then generated may be of limited utility to the seller. Moreover, the gain recognized is subject to the tax rates in effect in the year of recognition.
If, as many believe, tax rates will be higher in the future, your post-closing earnout payments will come with a higher tax cost. Finally, some part of the earnout payments will be treated as ordinary interest income.
To solve or lessen the impact of these problems, many sellers have opted to opt out of the installment method of reporting the gain on the sale. To do so, however, sellers must report and pay tax on the present value of the earnout payments. The seller’s valuation for tax purposes should be compared with the buyer’s valuation of the earnout which the buyer must undertake in order to properly account for the purchase.
Earnouts can bridge the valuation gap in the negotiation between buyers and sellers. However, they create their own unique problems and carry their own costs. It takes a significant amount of time to negotiate an earnout and have it properly analyzed and documented.
That additional time translates into additional professional costs. Moreover, an earnout keeps the seller involved in the business even though, in many instances, the seller is moving on to other priorities.
From the buyer’s perspective, the seller is looking over the buyer’s shoulder to make sure the business is being operated in order to maximize the earnout payment and not necessarily what is good in the long-term for the buyer.
Notwithstanding these shortcomings, earnouts do ensure that the competing objectives of the buyer and seller are met – the buyers pays for actual performance and not speculative conjecture, while the sellers get paid for the value they always knew was there.
Gary Q. Michel is a partner in the law firm of Ervin Cohen & Jessup, in Beverly Hills, California, where he chairs the firm’s tax law practice.