Tax Points – Below is a summary of the tax treatments of earn-outs. Remember, every situation is different. These are general guidelines and not specific advice. Do not enter into any transaction without review of tax issues by competent tax advisors.
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- Income tax treatment for the seller – earn-outs are recognized by the tax rules as an “installment sale” meaning that each payment received by the seller includes two components:
a. a portion of the “basis” is recovered (not taxed) and
b. a portion of the “gain” is received (taxed).
c. Some assets are excluded from the earn-out treatment, notably inventory and depreciable assets subject to depreciation recapture requirements. For these asset classes, the gain is recognized in the year of the sale, regardless of payment terms.
- Earn-out Contingencies – the final purchase price for a deal that has an earn-out component is not known at time of sale; it is “contingent” on some future event(s) as defined by the earn-out agreement. Examples of earn-out contingencies are:
a. meeting specified, agreed upon financial targets (gross revenue, gross profit, EBITDA etc),
b. customer retention,
c. contract renewals.
d. The final purchase agreement will include the formulas used to determine when the terms and conditions of the earn-out are satisfied and the seller gets paid.
- Final Purchase Price Determination – the final purchase price agreement will include the language regarding when the final purchase price is going to be determined. The final price can be:
a. Stated at a maximum price,
b. Determined within a defined period,
c. No maximum price and no defined period
- Interest on seller financing – remember that earn-outs are really a form of seller financing during the earn-out period. Therefore, interest must be separately stated; if not, a portion of the deferred payment could be reclassified by the IRS as interest
- “Opt out” provision – this is a non-revocable election made by the seller meaning that if the seller has a change of mind and wishes to revoke the opt-out election, the IRS must approve it first. The “opt-out” provision can only be elected n the year of sale. If the election is made, then the the fair market value of the contingent payments are taxed in the year of sale, even though the cash is received in subsequent years.
- Depreciation and amortization – this applies to the buyer. Depreciation and amortization begin when the payment is made, not when the deal is closed, meaning the tax benefits of depreciation and amortization are deferred until such payments are made
- 2013, New tax consideration – effective 2013, subject to various tax thresholds, there is a new tax of 3.8% imposed on the “net investment income”. The definition of “net investment income” includes the disposition of interests in partnerships and s-corporations. Point is, there is a new tax in town to consider.