Earnouts are a common feature of M&A transactions, particularly when the buyer and seller disagree on the value of the business. Rather than resolving that disagreement at closing, the parties agree that additional consideration will be paid later if certain milestones are achieved.
From a tax perspective, earnouts are generally treated as additional purchase price. That is good news for sellers because purchase price is typically taxed at capital gain rates.
However, problems can arise when earnout payments are tied to the continued employment of one or more selling shareholders.
The IRS may argue that an earnout conditioned on future services is not really purchase price at all. Instead, the IRS may contend that the payment represents compensation for services. If that argument succeeds, the payment may be subject to ordinary income tax rates, employment taxes, withholding obligations, and other compensation-related tax rules.
Fortunately, continued employment is not the end of the analysis.
Whether an earnout is treated as purchase price or compensation depends on all of the facts and circumstances surrounding the transaction. No single factor is determinative.
Proportionality. Perhaps the most important consideration is whether the earnout is paid proportionately to all sellers based on their ownership interests. If every seller receives a proportionate share of the earnout, that tends to support the position that the earnout is a return on capital rather than compensation for services.
Purpose. Another important consideration is the purpose of the earnout itself. Was the earnout included because the parties genuinely disagreed about the value of the business? Or was it included to provide additional compensation to key employees after closing? The answer can significantly influence the tax analysis.
Reasonableness. Reasonableness also matters. The overall purchase price, including the earnout, should represent a reasonable value for the business. Likewise, employees who are required to remain employed should generally receive reasonable compensation for their post-closing services independent of the earnout. When compensation is already reasonable, it becomes easier to argue that the earnout represents additional purchase price rather than disguised wages.
Form. The transaction documents are also critical. The parties should carefully consider how the earnout is described throughout the purchase agreement and related documents. Consistent drafting and reporting can help support the intended tax treatment.
As with many tax issues, careful planning before signing the deal can make a substantial difference. Earnouts are often negotiated primarily as business terms, but their tax consequences should not be overlooked.
If you are structuring an earnout or evaluating an acquisition agreement, it is worth considering these issues before the transaction closes rather than after the IRS raises questions.