Earnout Tax Treatment for Buyers and Sellers

An earnout is a contractual provision in a business acquisition where a portion of the purchase price is contingent on the company’s future performance. This arrangement allows a buyer to make additional payments to the seller only if the business achieves specific financial goals, such as a revenue target, after the sale. Earnouts are used to bridge valuation gaps when buyers and sellers have different expectations about a business’s future success. This structure, representing 10% to 50% of the total deal value, introduces tax complexities for both parties.

Seller’s Tax Reporting Methods

The Installment Method

The default tax reporting treatment for a seller with an earnout is the installment method, which is applied automatically unless the seller elects out. This approach allows the seller to defer gain on the sale, paying tax on the proceeds as they are received over time. This aligns the tax liability with the actual cash received from the contingent payments.

The method for calculating the gain varies with the earnout’s structure. If the contract states a maximum sale price, a gross profit percentage is applied to each payment to determine the taxable portion.

If there is no maximum price but a fixed payment period, the seller’s basis is recovered evenly over that period. For example, if the earnout is paid over five years, one-fifth of the basis is allocated to each year, and any excess payment is a taxable gain. In rare cases with neither a maximum price nor a fixed period, the basis is recovered over 15 years.

Electing Out (Closed Transaction Treatment)

Sellers can elect out of the installment method, which treats the transaction as “closed” for tax purposes in the year of the sale. This requires the seller to recognize the entire gain immediately, which includes the fixed initial payment plus the fair market value (FMV) of the contingent earnout rights. This election is irrevocable and must be made on a timely filed tax return for the year of the sale.

Determining the FMV of an earnout is a challenge, as the valuation must consider factors like the probability of hitting performance targets and the time value of money. The valuation can be scrutinized by the IRS, potentially leading to adjustments, additional taxes, and penalties. If actual earnout payments differ from the estimated FMV, the seller must account for these differences. If payments are less than the estimate, the seller recognizes a capital loss, and if they exceed the estimate, the excess is recognized as additional gain.

The Open Transaction Doctrine

The open transaction doctrine is a rarely permitted method for reporting gain, used only in extraordinary circumstances where the earnout has no ascertainable fair market value. A seller cannot simply choose this method; its use is dictated by the extreme uncertainty of the earnout’s value.

Under this doctrine, the seller first recovers their entire tax basis from the initial payments received. No gain is reported until the cumulative payments exceed the seller’s full basis. Once the basis is recovered, all subsequent payments are taxed as capital gain as they are received. The IRS heavily scrutinizes any use of this favorable method.

Buyer’s Tax Treatment

Establishing and Adjusting Basis

For the buyer, the tax treatment of an earnout centers on the basis of the acquired assets or stock. The initial basis includes the upfront cash paid, the fair market value of other property transferred, and any liabilities assumed.

As contingent earnout payments are made, they are added to the buyer’s basis. For example, a $500,000 earnout payment made in year three is added to the basis of the assets acquired in the original transaction. This basis adjustment is not retroactive; the basis is increased in the year the contingent payment is made. This affects calculations for future depreciation and any gain or loss if the buyer later sells the assets.

Impact on Depreciation and Amortization

The basis adjustments from earnout payments affect the buyer’s depreciation and amortization deductions. When a buyer acquires assets, the purchase price is allocated among them, and they are depreciated or amortized over their useful lives.

When an earnout payment increases the basis of these assets, the additional basis is also eligible for depreciation or amortization. For example, if an earnout payment increases the basis of an intangible with a 15-year life five years after the sale, the additional basis is amortized over the remaining 10 years. This allows the buyer to recover the cost of the earnout payments over time through increased tax deductions.

The Role of Imputed Interest

Explaining the Concept

When a sale involves deferred payments like an earnout, the IRS requires a portion of each payment to be treated as interest. This is known as imputed interest and reflects the time value of money. Even if the contract does not state an interest rate, tax law will impute one.

This mandatory rule prevents parties from converting what is economically interest into part of the purchase price. The amount of imputed interest reduces the portion of the payment treated as sales price.

Impact on the Seller

For the seller, the imputed interest rule has an unfavorable tax consequence. The portion of each earnout payment recharacterized as interest is taxed as ordinary income, not as capital gain. Ordinary income tax rates are higher than the preferential long-term capital gains rates. This means the seller will not receive full capital gains treatment on the payments and must report the interest portion as ordinary income, which can increase the overall tax liability from the sale.

Impact on the Buyer

From the buyer’s perspective, the imputed interest rule is favorable. The portion of the earnout payment classified as interest is deductible as an interest expense in the year the payment is made. This provides an immediate tax benefit that reduces the buyer’s taxable income.

This treatment is more advantageous than adding the full payment to the basis of acquired assets, which is recovered over time through depreciation. This tax treatment is the mirror image of the seller’s: what is ordinary income to the seller is a deductible expense for the buyer.

Applicable Federal Rates (AFR)

The amount of interest imputed on a deferred payment is determined using the Applicable Federal Rates (AFR), which are published monthly by the IRS. The AFR is the minimum interest rate that must be charged on a private loan to avoid the imputation of interest. If the sales agreement fails to state an adequate interest rate, the IRS will use the AFR to calculate the imputed interest. This calculation separates each contingent payment into a principal portion (sales price) and an interest portion.

Character of Gain or Loss

Capital Gain Treatment

For a seller, the gain recognized from earnout payments is treated as a capital gain, provided the business was a capital asset. Long-term capital gains are taxed at preferential rates compared to ordinary income. The portion of each payment not recharacterized as imputed interest is considered part of the sales price and contributes to the capital gain. If the seller sold stock in a corporation, the gain is a capital gain, but if the sale was structured as an asset sale, the character depends on the individual assets sold, as some assets like inventory produce ordinary income.

Potential for Ordinary Income

A risk for sellers is the potential for earnout payments to be reclassified as ordinary income instead of capital gain. This can happen if the payments are tied to the seller’s continued employment or consulting services. The IRS may determine the payments are disguised compensation for services rather than for the business’s goodwill.

Factors include whether the seller must provide services to receive the earnout, if the seller is otherwise adequately compensated, and if payments are linked to individual performance rather than the business’s overall performance. If payments are treated as compensation, they are taxed at higher ordinary income rates and are subject to payroll taxes. For the buyer, characterizing payments as compensation allows for an immediate tax deduction, creating a conflict of interest.

Treatment of Losses

A seller can realize a loss if the total payments received are less than the seller’s tax basis in the business. The tax treatment of this loss depends on the reporting method chosen. If the seller used the installment method, a loss is recognized at the end of the earnout period. If the seller elected out, a capital loss is recognized in a later year if the total payments fall short of the fair market value reported at the time of sale. The character of the loss is typically capital, which can be used to offset capital gains and a limited amount of ordinary income.