Are Earnouts Taxed as Capital Gains?

Selling a business often involves complex arrangements, and earnouts are a common feature designed to bridge valuation gaps between buyers and sellers. These contingent payments, made after the sale based on the business’s future performance, introduce unique considerations for both parties. A frequent question for individuals receiving these payments is whether earnouts are taxed as capital gains. The tax treatment of earnouts is not always straightforward, as various factors can influence how these payments are characterized. This article explores the nature of earnouts and their tax implications for recipients, detailing the conditions for capital gains treatment.

Understanding Earnouts

An earnout represents a portion of the purchase price of a business that is contingent upon the achievement of specific financial or operational targets by the acquired entity after the sale. Its receipt is deferred and depends on the business’s future success, distinguishing it from an upfront, fixed payment. Earnouts are a mechanism to align the interests of the buyer and seller post-acquisition.

Earnouts are included in acquisition agreements for several reasons. They help bridge differences in valuation expectations, especially when there is uncertainty about the target company’s future performance or market conditions. These arrangements also incentivize sellers to ensure a smooth transition and continued strong performance of the business after the sale. Earnouts can also mitigate risk for the buyer by tying a portion of the purchase price to actual future results. Common metrics for earnout calculations include revenue targets, earnings before interest, taxes, depreciation, and amortization (EBITDA), or the achievement of specific operational milestones.

General Tax Treatment of Earnouts

Earnout payments are frequently treated as ordinary income if they are not clearly linked to the sale of underlying business assets or stock, or if they are considered compensation for services. The Internal Revenue Service (IRS) generally views contingent payments as additional compensation rather than part of a sale, especially if the seller continues to provide services to the acquired business.

When earnout payments are deferred, a portion of each payment may be recharacterized as interest income by the IRS, even if the sale agreement does not explicitly state it. This concept is known as imputed interest, or original issue discount (OID), under tax law. The IRS requires a reasonable interest rate be applied to deferred payments; if the contract rate is too low or nonexistent, the IRS will impute interest using the Applicable Federal Rate (AFR). This imputed interest portion is always taxed as ordinary income, regardless of how the principal portion of the earnout is taxed.

While ordinary income and imputed interest are common, earnouts can, under specific circumstances, qualify for capital gains treatment. This occurs if the payments are clearly part of the sale of a capital asset, such as business stock or a partnership interest. The characterization of these payments depends on analysis of the sale agreement and the seller’s ongoing involvement with the business. This distinction is important for tax planning, as capital gains are typically taxed at lower rates than ordinary income.

Conditions for Capital Gains Treatment

For an earnout to be taxed as capital gains, it must be part of the sale of a capital asset. This includes assets like stock in a C-corporation, S-corporation, or a partnership interest. Certain business assets that qualify as capital assets, such as goodwill, can also be part of a capital gains transaction. Earnouts tied to personal services provided by the seller are typically treated as ordinary income.

When the total purchase price of an asset cannot be reasonably determined at the time of sale due to contingencies like an earnout, certain tax principles may apply. Historically, the “open transaction” doctrine allowed sellers to recover their basis in the asset first, with subsequent earnout payments becoming taxable only after full basis recovery. These payments would then be eligible for capital gains treatment. However, this approach is rare today and generally allowed only when the earnout’s value is truly unascertainable, meaning there is no reasonable method to estimate its future value.

Earnouts can sometimes be treated under installment sale rules, even when the total price is contingent. An installment sale allows the seller to defer recognition of gain until payments are received. If an earnout is part of an installment sale, the gain is recognized proportionally as payments are received. Each payment in an installment sale with an earnout may have both a capital gains component and an imputed interest component. When the selling price is not fixed, basis is typically recovered ratably over a fixed number of years, or over the expected term of the earnout if a maximum period is specified.

The seller’s continued involvement with the acquired business can complicate the tax treatment of earnout payments. If the seller enters into employment or consulting agreements with the buyer, this arrangement might cause earnout payments to be recharacterized as compensation, taxed as ordinary income, rather than proceeds from the sale of a capital asset. Sale agreements must clearly delineate between payments for the business sale and payments for any ongoing services provided by the seller. The IRS scrutinizes such arrangements to ensure proper classification.

Reporting Earnout Income

Reporting earnout income requires attention to ensure proper tax characterization. For payments that qualify as capital gains, sellers typically report them on Schedule D, Capital Gains and Losses. This form summarizes capital gain and loss transactions and is supported by Form 8949, Sales and Other Dispositions of Capital Assets, where individual sales transactions are detailed. These forms ensure lower capital gains tax rates are properly applied.

For earnout amounts characterized as ordinary income, including any imputed interest or compensation for services, different forms are used. Imputed interest is generally reported on Schedule B, Interest and Ordinary Dividends. Payments considered compensation for services might be reported on Schedule C, Profit or Loss from Business, if the seller is operating as an independent contractor, or on Form 1040, Line 1, if treated as wages. Buyers typically issue Form 1099-MISC or Form 1099-NEC to report earnout payments, which may require the seller to reclassify the income based on the payment’s nature.

Earnout income is generally recognized in the tax year it is received, not necessarily when the sale agreement is initially signed. This means tax implications can span multiple tax years, as payments are often spread out over several years based on the business’s performance. Each year, the portion of the earnout received must be properly characterized and reported. The seller’s basis in the sold asset is applied against the earnout payments to determine the taxable gain. If total earnout payments received are ultimately less than the seller’s adjusted basis in the asset, this can result in a capital loss, which may be deductible subject to certain limitations.