How Are Earnouts Taxed for Buyers and Sellers?

An earnout represents a portion of the purchase price in a business acquisition that is contingent upon the acquired business achieving specific future performance metrics. This mechanism helps bridge valuation gaps between buyers and sellers, allowing a deal to proceed when there is disagreement on the target company’s worth. Earnouts also serve to motivate sellers to ensure the continued success of the business post-acquisition, as their future payments depend on meeting agreed-upon financial or operational targets.

Seller’s Tax Considerations for Earnouts

Earnout payments are treated as contingent payment sales under Internal Revenue Code Section 453. This method allows sellers to report gain from the sale over time, as payments are received, rather than all at once in the year of sale. The gain recognized in each tax year is a portion of the payment received, calculated based on the seller’s gross profit percentage from the sale.

The character of income from earnout payments mirrors the character of the underlying asset sold. If the sale involved a capital asset, such as stock, the portion of the earnout payment attributable to the purchase price will be taxed as a capital gain. However, sellers must consider the imputed interest rule under Internal Revenue Code Section 483 or 1274. These rules require that a portion of each earnout payment, even if not explicitly stated as interest, be recharacterized as interest income.

This recharacterized imputed interest is taxed to the seller as ordinary income, rather than capital gain. The amount of imputed interest is calculated using the Applicable Federal Rate (AFR) in effect at the time of the sale, which is published monthly by the IRS. This recharacterization means sellers receive a mix of capital gain and ordinary income with each earnout payment. For example, if an earnout payment of $100,000 is received, and $5,000 is deemed imputed interest, only $95,000 is considered part of the sales price subject to capital gains treatment.

The recovery of the seller’s tax basis in the sold assets or stock is an important aspect. If the maximum selling price of the earnout is determinable, the basis is recovered proportionately over the period payments are expected. When the maximum selling price cannot be determined, the seller’s basis is recovered over a 15-year period. This ensures that the seller’s investment in the business is accounted for before all payments are treated as taxable gain.

The tax implications can also vary depending on whether the transaction is structured as an asset sale or a stock sale. In a stock sale, the entire gain from the earnout payments retains the character of capital gain, subject to the imputed interest rules. An asset sale, conversely, requires the purchase price, including earnouts, to be allocated among the various assets sold, such as tangible property, inventory, and intangible assets like goodwill. Each allocated amount then has its own tax character, potentially leading to a mix of ordinary income and capital gains depending on the specific asset.

Should the earnout payments not materialize as expected, leading to a total consideration less than the seller’s basis, the seller may recognize a loss. The treatment of this loss depends on the character of the original sale. If the original sale would have resulted in a capital loss, any unrecovered basis would be treated as a capital loss in the year the final payment is received or when it becomes clear no further payments will be made. This ensures that the seller can account for their full investment, even if the anticipated earnout income does not materialize.

Buyer’s Tax Considerations for Earnouts

From the buyer’s perspective, earnout payments are considered part of the purchase price for the acquired business or its assets, rather than a deductible business expense. This means the buyer cannot immediately deduct the earnout payments in the year they are made. Instead, these payments contribute to the buyer’s tax basis in the acquired assets or stock.

As earnout payments are made, they increase the buyer’s tax basis in the acquired assets or stock. This basis adjustment occurs incrementally with each payment, reflecting the actual cost incurred by the buyer for the acquisition.

The increased basis resulting from earnout payments provides a tax benefit to the buyer over time through depreciation or amortization. Tangible assets, such as equipment or real estate, can be depreciated over their useful lives, while intangible assets, like goodwill or customer lists, are amortized over 15 years under Internal Revenue Code Section 197. This allows the buyer to recover the cost of the acquisition, including the earnout portion, through annual tax deductions.

The imputed interest portion of the earnout payment, which is taxed as ordinary income to the seller, is treated as a deductible interest expense for the buyer. The buyer can deduct this interest expense in the year the earnout payment is made.

Specific Earnout Scenarios and Reporting

In certain circumstances, an earnout may be structured not as part of the purchase price but as compensation for the seller’s continued services post-acquisition. If earnout payments are explicitly tied to the seller’s ongoing employment or performance of specific services, they may be recharacterized as ordinary compensation income to the seller. This means the seller would report these payments as wages or self-employment income, subject to ordinary income tax rates and potentially payroll taxes.

For the buyer, earnout payments characterized as compensation for services become a deductible business expense, rather than an addition to the asset’s basis. The buyer can deduct the full amount of these payments in the year they are paid. This distinction between purchase price and compensation is determined by various factors, including the terms of the acquisition agreement, the seller’s continued involvement, and the reasonableness of the compensation relative to the services provided.

Sellers involved in contingent payment sales, including earnouts, are required to report these transactions to the IRS using specific forms. Form 6252, Installment Sale Income, is commonly used to report the gain recognized each year from contingent payment sales. This form helps sellers calculate the taxable portion of each payment received and track their basis recovery.

Any imputed interest portion of the earnout payment, as determined under Section 483 or 1274, is reported to the seller on Form 1099-INT, Interest Income. This form notifies the seller of the ordinary income portion of their earnout payment that is subject to taxation.