After a lull in 2022, merger and acquisition (M&A) activity has picked up this year as expected. However, due to ongoing economic uncertainty, earnouts are likely to play a big role in many deals — which may carry significant tax consequences.
Also known as a contingent consideration, an earnout is a mechanism that promises future payments to the seller in addition to an upfront payment.
The ins and out of an earnout
Today, the gap between what sellers want and what buyers are willing to pay has widened due to several valuation variables — expected cash flows, pricing multiples and rates of return.
Earnouts can help bridge the valuation gap and facilitate deal making by offering a contingent payment that the seller only receives when specific performance targets are met by an agreed-upon date. For example, 10% of the purchase price might be contingent on whether an acquired company meets a specific revenue or earnings target over a two-year period.
Dueling tax treatments
Depending on how a deal is structured, earnout payments may be treated as either part of the purchase price or compensation to the seller for services rendered.
If an earnout is deemed part of the purchase price, it’s taxed at the capital gains rate, generally 15% or 20%. The 3.8% net investment income tax also may apply in this situation. However, if it’s considered compensation, it’s taxed at the applicable ordinary income rate, which can be as high as 37%. (Plus, it’s subject to payroll taxes.)
The characterization of an earnout affects the buyer, too. An earnout that’s treated as compensation is immediately deductible. On the other hand, the earnout must be capitalized and amortized over time if it’s considered a deferred payment on the purchase price.
Compensation vs. purchase price
Several factors can indicate whether an earnout is part of the purchase price or compensation for the seller’s services:
- Is the seller required to perform services to receive the earnout payment?
- Are they receiving separate reasonable compensation for those services?
- Is the seller’s employment required for the entire earnout period?
- Is the earnout paid even if the seller is terminated?
- How does the earnout amount compare with reasonable compensation for the seller’s services?
Another important consideration is whether there’s any evidence of intent in documentation related to the transaction. For example, does correspondence show a difference of opinion on the target’s valuation and, in turn, the purchase price? Did the deal close after an earnout was added? Does the letter of intent connect the earnout to the seller’s continued employment?
Do your due diligence
When buying or selling a business, always consult with your tax advisor to ensure the transaction documents and structure reflect the intended tax results. The professionals at Magone & Company can help you navigate M&As to help achieve the most favorable tax position. Call us today at (973) 301-2300 for a specific evaluation of your situation.
This document is for informational purposes only and should not be considered tax or financial advice. Be sure to consult with a knowledgeable financial or legal advisor for guidance that is specific to your unique circumstances.