Tax Treatment of Earnouts Kevin W. Kaiser Buyers and sellers often do not agree on the value of an acquisition target, making the structure and mix any M&A transaction are the amount, timing and of consideration a contentious issue. These different character of the gain or loss on sale. viewpoints are often resolved by tying a portion of the purchase price to the future performance of the Q: How are earnouts taken into account for tax? acquired business. The variety of contingent purchase A: Generally, an earnout should provide for deferred price arrangements, or earnouts, are limited only by the gain recognition by the seller. The tax laws commonly creativity of the dealmakers. provide for the recognition of the transaction in one of three ways: (1) closed transaction—seller recognizes Understanding and managing the tax treatment of the gain or loss currently, regardless of whether the earnouts can benefit both buyers and sellers. Below earnout is achieved; (2) open transaction—seller are some frequently asked questions relating to the tax recognizes gain after basis in the property sold is treatment of earnouts. recovered; and (3) installment sale—seller recognizes ©Copyright, Lindquist & Vennum PLLP, 2011 the income over the periods during which earnout Q: What are the primary tax considerations when payments are received. The method used to report the structuring a deal to include an earnout? transaction will govern the timing and amount of the A: The threshold question is whether or not any portion recognized gain or loss. It should also be noted that of the potential earnout is taken into account by the there may be situations in which a seller would choose buyer and seller in the year of the sale. Depending to recognize the sale of a business currently and forego on the terms of the transaction, gain or loss may be deferral treatment, such as when a business is sold at a recognized in the year of the sale, or may be deferred in loss, or when it is known or expected that tax rates will whole or in part until earnout payments are received. increase in the future. Q: What other tax issues arise when structuring Q: Are buyers and sellers free to choose which reporting transactions with earnouts? method they use? A: Typically, the three elements that must be analyzed A: No. The proper reporting method will be governed and resolved to correctly plan and report the tax by the terms of the earnout. Most sellers prefer either treatment of open transaction accounting or installment reporting. These two methods defer gain recognition and generally compete as ordinary income. An example of contingent best match the receipt of cash with the gain recognition. consideration in a compensation agreement would Open transaction accounting is available only when the be employer restricted stock. The former owner of a receipt of the earnout is speculative and the ultimate business may agree to perform services for the buyer realization is highly uncertain. The installment reporting in exchange for buyer-restricted stock that vests over a rules allocate the gain recognition over the life of the period of years (e.g., one-third vesting each year over earnout. Certain earnout terms, such as maximum three years) with forfeiture of any stock that remains payout and payment period, will determine if and how unvested upon termination of employment. the installment reporting recognition rules will apply to the transaction. These types of compensatory arrangements often result in the seller-employee recognizing compensation Q: How are the recognized gains and losses income (and the buyer-employer recognizing the characterized for tax purposes? corresponding deductible expense) when the A: Generally, gains and losses are treated as arising restrictions on the seller-employee lapse. from a property transaction. Accordingly, sales of stock held as a capital asset will obtain capital gain or Q: Do the earnout tax rules also apply to nontaxable loss treatment. In an asset deal, the sale of trade or transactions? business property will typically be subject to the special A: Yes. The earnout rules also apply to nontaxable rules providing for capital gains and ordinary losses. In transactions. Nontaxable stock and asset deals can be addition, depreciation recapture rules may cause certain structured with contingent consideration. However, gains recognized in asset deals to be characterized as when the mix of consideration in a nontaxable ordinary income. In the event that installment method transaction (e.g., a merger) includes contingent reporting is used, a portion of the recognized income payments, additional tax issues arise and the complexity may be characterized as interest income. of the subject transaction increases. Q: Do the earnout rules apply to post-closing seller As the deal flow continues to gain strength, many advisors services arrangements and noncompete covenants? will be working with buyers and sellers using earnouts A: Yes. These arrangements are common and will to bridge the gap on valuation. Being aware of the tax influence how the earnout tax accounting rules are treatment of these arrangements and knowing how to applied. If the seller’s right to receive some portion of optimize it can inject additional value into a transaction. the earnout is conditioned on the provision of services or the agreement to a non-compete covenant, then the seller may have to recognize the portion of the consideration relating to the services or non- Kevin W. Kaiser Partner 612.371.2467 [email protected] lindquist.com/kkaiser Page 2