Most M & A transactions involve an earnout whereby part of the purchase price is paid to the seller after closing, typically after one, two, or three years. Earnout amounts are viewed by the seller as part of the purchase price and therefore subject to capital gains tax in a stock sale or in an asset sale where the earnout amount is allocated to capital gain items. Care must be taken to assure that the earnout amount does not turn into a compensation item for the seller, subjecting it to much higher ordinary income tax rates. Often, the “earning” of the earnout is tied to the seller maintaining employment for a period of time and/or meeting sales or production targets. Tying the earnout to these factors could turn it into compensation to the seller. To avoid that, the purchase agreement should state the intention of the buyer and seller that the earnout is a component of the purchase price, is not considered compensation for future services, is intended to protect the buyer’s investment in the business being purchased, and that any compensation being paid to the seller under a separate employment agreement is deemed to be reasonable compensation for the services to be rendered. Carefully crafting the earnout provision can help to avoid an unpleasant notice from the Internal Revenue Service years later that the earnout amount is compensation and that substantially more tax is owed by the seller.
If you have any questions about this or any other M&A issue,
please contact Glenn Solomon at firstname.lastname@example.org or 443-738-1522.
ABOUT GLENN D. SOLOMON
email@example.com | 443-738-1522
Glenn D. Solomon is a principal at Offit Kurman and has provided counsel to businesses and business owners for more than twenty-five years. He has extensive experience in the purchase and sale of businesses, structuring ownership agreements, and advising companies in financial distress.
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