An earnout is a deferred contingent payment tied to the success of the business entity being purchased and can be structured in various ways. An earnout provision has become commonplace in purchase agreements as an effective way for parties to bridge the gap between valuation disagreements and the resulting purchase price. Earnouts provide continued motivation for both sides to act in favor of the business’ success. This article focuses on (1) the tax implications that an earnout creates, whether it is viewed as compensation or capital gains, and (2) the requirement of an interest component, and what the IRS will do if the earnout lacks it.

Tax Implications

The parties involved in an earnout provision will likely have competing views on how to classify the earnout for tax purposes. An earnout may be viewed as either compensation or as part of the purchase price. As compensation, the earnout must be taxed as ordinary income to the recipient and is treated as a deductible business expense to the payor. As part of the purchase price, the earnings may be taxed at preferential capital gains rates.

Often, the seller may want the earnout to be classified as part of the purchase price, while the buyer will push for it to be treated as compensation. Because of this conflict, most purchase agreements specify how this classification will be determined. However, the IRS considers the characteristics of the earnout itself to determine its tax treatment, even if those characteristics differ from the intent expressed in the agreement.

Although there is no official framework to ensure one classification over another, the following factors can contribute to classification:

• Whether the payments are made in proportion to the target owners’ equity interest in the target (indicative of sale proceeds).
• Whether the payee was required to be employed by the target as of the date of the transaction, or a subsequent date, to be eligible to receive the payment (indicative of compensation).
• Whether the person receiving the payments is otherwise adequately compensated for the services provided after the acquisition (indicative of sale proceeds).
• Whether the overall payments that purport to be for target equity represent a reasonable value of the target business (indicative of sale proceeds).
• Whether the amount of the payments varies based on length and type of service (indicative of compensation).
• Whether the transaction documents classify the payments as compensation or proceeds of sale.
• How the parties report the payments to the IRS, and whether the reporting of both parties is consistent.
• How the payments are reported for nontax purposes, including for financial accounting purposes.

Issues of classification often arise when the seller (or owner) remains employed by the buyer to assist in the business transition. The parties may intend for the earnout to be tied only to the earnings of the business, yet also tie the seller’s employment to that earnout, or vice versa. These situations are exactly what create potential problems with the IRS. When tested in the federal court system, payments tied to ongoing services are likely to be treated as compensation, whereas payments tied to the sale of a capital asset with no service component are likely to be treated as capital gains.

Depending on the business deal and intent, parties should carefully structure any earnout provisions consistent with their intended treatment, considering the factors above. These classification considerations should be carefully addressed during the drafting phase.

Interest Component

As contingent payments, earnouts that constitute additional purchase price (but not compensatory earnouts) are usually subject to Code § 483 and its interest imputation rules. Section 483 requires interest on specific types of deferred contingent payments and calculates how that interest will be imputed if adequate interest is lacking.¹

Earnout provisions that contain payments made more than one year after the date of sale must have an interest component. If adequate interest is not stated, the IRS will impute interest on all payments made more than six months after the date of sale. In imputing the interest, the IRS takes the total amount of the deferred payments and subtracts their present value. The discount rate equals the Applicable Federal Rate (AFR). The amount of total deferred payment in excess of the present value is treated as interest, and the present value is treated as the principal.

This imputed interest reduces the purchase price for tax purposes, so knowing whether an earnout is subject to interest calculations could be the difference of millions of dollars. The decrease in the actual purchase price for interest replacement also reduces potential capital gains while increasing ordinary income for the seller through interest payments.

Given the economic consequences, a well-drafted earnout provision and strict adherence to it are essential. It allows both parties to maximize their expected benefits and have a solid understanding of what to expect throughout the life of the purchase.