Earnouts: Ordinary Income or Capital Gains

My prior NCBarBlog post, Section 453 Trap for S Corporation Asset Sales, notes the purchase price for a business often includes an earnout that provides contingent consideration based on the performance of the business after the sale. Earnouts address valuation disputes between the buyer and seller by providing for upward adjustments to the purchase price if the business performs well (i.e., meeting a set metric) during a post-closing period. Earnouts are generally reported under the installment sale method of Section 453.

Sometimes, particularly in service industries, buyers push for tying earnouts to a seller/employee’s continued employment. If the employee leaves employment before the end of a specified period, the earnout may be forfeited in whole or in part. From a buyer’s perspective, the seller/employee is incentivized to continue to contribute to the business. However, that creates a tax issue for seller. Cases like Lane Processing Trust v. United States, 25 F.3d 662 (8th Cir., 1994), have held payments made to seller/employees are wages rather than sale proceeds because they were “conditioned not only on prior service, but also on continuing employment.” Where an earnout is conditioned on the future employment of the seller/employee, it creates a risk that the payment is, in substance, compensation for the services of the employee rather than part of the purchase price for the sale of the business.

Treatment of the earnout as compensation for services would provide the buyer with a beneficial ordinary business deduction rather than requiring the buyer to capitalize the payment and claim future depreciation or amortization deductions. The result for the seller, however, would be a disaster because the wage income would be subject to higher income taxes (ordinary income rates rather than long-term capital gains rates) and to employment taxes that otherwise would not apply. Sellers should generally resist deferred payments being contingent on work requirements.

John G. Hodnette is a partner with Fox Rothschild, LLP in Charlotte.