Another Look at U.S. Federal Income Tax Treatment of Contingent Earnout Payments

The sale of a company in an M&A transaction often involves consideration to the selling shareholders that is deferred and contingent on subsequent events in the life of the company, such as the post-acquisition performance of the business (an “earnout ”). Earnouts are typically used where a buyer and seller disagree on the value of the target company or its business as of the date of the transaction. Through the use of earnout payments, buyer and seller can defer this valuation decision to a later point in time, and link it to the performance of the business or the target company’s product sales. Such valuation difference can be especially prominent for early-stage companies, with unproven products or technologies, or other companies for which historical results may be unreliable indicators of future value.

A typical earnout provision in an M&A agreement could provide, for example that, if the target company’s EBITDA percentage for the measurement period is greater than a certain percentage (e.g., 15%) the selling shareholders will be entitled to receive an additional consideration for their stock. The additional consideration amount could be determined by multiplying, the target company’s revenues for the measurement period by a certain percentage (e.g., 0.025).

Often, the earnout payments made by the buyer are contingent on whether certain employees of the acquired company or business remain employed by the company for a specified period of time after the acquisition. When an employee is also a shareholder of the acquired target company, an issue can arise as to whether an earnout payment that is contingent on continued employment represents compensation for the employee-shareholder’s services, or consideration for the employee-shareholder’s stock. The U.S. federal income tax stakes are significant.

A selling shareholder generally recognizes capital gain or loss on the sale of stock. The amount of gain (or loss) recognized is the excess of the amount realized over the shareholder’s basis in the stock. The amount realized usually consists of cash received and a note or another right to deferred payments or the fair market value of any other property received. Installment method reporting applies to a gain on a sale if at least one payment is to be received after the tax year of the closing.

Read the full article, Another Look at U.S. Federal Income Tax Treatment of Contingent Earnout Payments.

Originally published in the Global Tax Weekly on July 17, 2014.