Contingent Consideration Tax Treatment for Buyers & Sellers

Contingent consideration is part of the purchase price in a business sale that is paid only if certain future events occur. These arrangements, often called earnouts, are used to bridge a valuation gap when a buyer and seller disagree on the target company’s worth. For example, a seller might receive additional payments if the business achieves specific revenue targets after the sale. While these payments are a practical tool, their tax treatment introduces complexity with distinct consequences for both the buyer and the seller.

Seller’s Tax Implications

When a seller receives contingent payments over time, the default tax treatment falls under the installment sale rules. This method allows the seller to defer recognition of the gain on the sale. Instead of paying tax on the entire gain in the year of the transaction, the seller recognizes a portion of the gain as each payment is received. This approach aligns the tax liability with the actual cash flow from the sale.

A central concept is imputed interest. If the sales agreement does not specify an adequate rate of interest on deferred payments, the IRS recharacterizes a portion of each payment as interest income. This interest portion is taxed to the seller at ordinary income tax rates, which are higher than capital gains rates.

The remainder of each payment is treated as principal. This principal is divided into a tax-free return of the seller’s basis and a taxable capital gain. The resulting gain is treated as a long-term capital gain if the seller held the asset for more than one year, which is taxed at preferential rates.

Sellers have sometimes used the “open transaction doctrine,” where no gain is reported until they have fully recovered their entire basis. Subsequent payments are then treated as capital gain. However, the IRS and courts view this as a rare exception, applicable only when the fair market value of the contingent consideration is not reasonably ascertainable.

Buyer’s Tax Implications

For the buyer, tax treatment focuses on establishing the tax basis of the acquired assets. The initial basis is determined by cash paid and the fair market value of property given at closing. This basis determines future depreciation or amortization deductions.

As the buyer makes contingent payments, the principal portion is added to the asset’s basis. This increase occurs only when the contingency is resolved and the amount becomes fixed. For intangible assets like goodwill, this additional basis is amortized over a 15-year period.

The interest component of each payment, whether stated or imputed, is treated as interest expense for the buyer. The buyer can deduct this amount as an ordinary business expense in the year it is paid or accrued, subject to certain limitations. This provides a current tax deduction.

The classification of payments is a point of negotiation. Buyers may prefer to characterize payments as compensation if the seller remains an employee, as compensation is deductible. Sellers prefer payments to be part of the purchase price to receive capital gains treatment. The agreement’s structure and the seller’s ongoing role determine the final tax classification.

Structuring and Reporting Contingent Payments

The structure of the contingent payment agreement dictates how a seller recovers their basis under the installment method. The rules for basis recovery depend on the earnout’s design, which falls into one of three scenarios.

Stated Maximum Selling Price

If the agreement specifies a maximum selling price, the seller’s basis recovery is determined using a gross profit percentage. This percentage is calculated based on the maximum price and applied to each principal payment to determine the taxable gain. This method ensures basis is recovered proportionally over the life of the potential payments.

Fixed Payment Period

When an agreement has a fixed payment period but no stated maximum price, the seller’s basis is recovered ratably over the fixed term. For instance, if the agreement calls for payments over a five-year period, one-fifth of the basis is allocated to each year. If a payment in any year is less than the allocated basis, the unrecovered basis is carried forward.

No Maximum Price or Fixed Period

In the absence of both a stated maximum price and a fixed period, Treasury Regulations provide a default rule. The seller is required to recover their basis ratably over a period of 15 years. If the payment obligation is satisfied for an amount less than the seller’s basis, the unrecovered basis can be deducted as a loss.

Sellers must report the transaction on IRS Form 6252, Installment Sale Income. This form is filed with the tax return for the year of the sale and for every subsequent year a payment is received. On the form, the seller must provide details of the sale, calculate the gross profit, and determine the taxable portion of each payment. Proper and consistent reporting on this form is required for compliance with the installment sale rules.