Earnout Payments: Purchase Price or Compensation?

Earnout payments can either be treated as part of the purchase price or as compensation for services, and this distinction significantly affects taxes for both buyers and sellers. Here's the key takeaway:

• If classified as purchase price: Sellers benefit from lower long-term capital gains tax rates (up to 20%), while buyers must capitalize the expense and amortize it over 15 years.
• If treated as compensation: Sellers face higher ordinary income tax rates (up to 37%) and employment taxes, but buyers can deduct the payments immediately.

The IRS uses a "facts-and-circumstances" test to determine classification, considering factors like employment status, payment conditions, and equity distribution. Sellers can improve their tax outcomes by structuring earnouts to avoid employment ties and ensuring payments are proportional to ownership stakes. Buyers, on the other hand, may prefer compensation treatment for immediate tax benefits but must account for payroll tax obligations.

Key Points to Remember:

• Payments tied to employment are more likely classified as compensation.
• Proportional payments to all shareholders support purchase price classification.
• Buyers and sellers often have conflicting tax preferences.

Proper planning and clear documentation are essential to align the interests of both parties and minimize tax burdens.

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What Determines Tax Treatment of Earnouts?

The IRS uses a "facts-and-circumstances" test to decide whether an earnout reflects the business's value or compensates for future services. The distinction lies in the earnout's purpose: is it tied to the business's inherent value, or does it reward future contributions?

Several factors come into play. For instance, employment status is a major indicator. If an earnout depends on continued employment, it’s often classified as compensation. On the other hand, earnouts distributed to all former shareholders based purely on equity ownership - regardless of employment - usually point to purchase price treatment. Additionally, if a seller receives a separate, market-rate salary for post-closing services, it strengthens the argument that the earnout is part of the purchase price rather than disguised wages.

The negotiation history also plays a role. If documentation shows the earnout was designed to resolve valuation differences between the buyer and seller, this supports its classification as purchase price. However, if earnouts are paid only to employee-sellers while excluding non-employee shareholders, the IRS often views these as compensation.

Let’s explore how employment status, compensation levels, and service requirements affect earnout classification.

Seller's Employment After the Sale

When a seller stays on as an employee after the sale, the IRS examines the connection between employment and earnout payments. Clauses that cancel earnouts if the seller resigns or is terminated raise concerns. These conditions often resemble deferred compensation arrangements rather than payments tied to the business’s value.

"Generally, if earnouts are conditioned on future services, then those conditions indicate compensation." - Mary Van Leuven, Director, Washington National Tax, KPMG LLP ^[4]

A key case, Lane Processing Trust v. U.S., highlights this principle. The 8th Circuit Court of Appeals ruled in 1994 that payments to employee-owners after an asset sale were compensation because they depended on continued employment ^[3]. To avoid this classification, structuring earnouts so they remain payable even in cases of death or disability can help reinforce their status as purchase price.

Payment Amounts Compared to Reasonable Compensation

Another important factor is whether the payment aligns with reasonable compensation for services. A below-market salary after the sale might suggest the earnout is being used to supplement wages, while a separate market-rate salary supports the argument that the earnout is part of the purchase price.

"If the compensation paid is reasonable for the services rendered, and if the amount of the earnout payment brings the total purchase price within a reasonable range of value for comparable businesses, the earnout payment should be treated as additional consideration for the business." - Louis Vlahos, Partner, Rivkin Radler LLP ^[3]

It’s crucial to ensure the total deal value - base price plus earnout - reflects the fair market value of similar businesses. If the total amount significantly exceeds comparable valuations, the IRS may suspect part of the payment is compensation disguised as purchase price.

Service Requirements for Payment

Earnouts tied to a seller’s ongoing services are more likely to be classified as compensation. The closer the payment is linked to the seller’s individual contributions, the harder it becomes to argue that it’s part of the purchase price. This risk increases when earnout metrics depend on the seller’s performance rather than the overall success of the business.

For example, the case R.J. Reynolds Tobacco Co. v. United States (1957) demonstrated that pro-rata, equity-based distributions qualify as dividends rather than compensation ^[4]. In cases where earnouts are distributed based on equity ownership rather than service conditions, they are more likely to be treated as part of the purchase price.

Tax Implications for Sellers: Purchase Price Treatment

When earnouts are treated as part of the purchase price, sellers can benefit from lower taxes due to long-term capital gains treatment. This means a maximum federal rate of 20%, plus an additional 3.8% Net Investment Income Tax for high earners, compared to ordinary income rates that can go as high as 37%. The difference in tax rates can lead to significant savings, allowing sellers to keep more of the proceeds from the sale.

Capital Gains Tax Rates

Classifying earnouts as purchase price subjects them to long-term capital gains tax rates. These rates top out at 20% federally for assets held longer than one year. For high-income earners, the 3.8% Net Investment Income Tax applies as well, resulting in a maximum combined rate of 23.8% ^[3].

"The maximum Federal rate for ordinary income is 37% whereas the maximum rate on capital gain is 20%." - Louis Vlahos, Partner, Farrell Fritz, P.C. ^[3]

To illustrate, consider a $1 million earnout payment. Under capital gains treatment at 23.8%, the tax owed would be approximately $238,000. Compare that to ordinary income treatment, where taxes could reach $370,000. That’s a difference of around $132,000 - a substantial amount saved.

Next, let’s look at how structuring earnouts to avoid ordinary income tax can further benefit sellers.

Avoiding Ordinary Income Tax

Purchase price treatment offers another advantage: the option to defer taxable gains using the installment method. If earnouts are classified as compensation, they would be taxed as ordinary income at rates up to 37%, plus state taxes, and would also trigger payroll taxes.

However, when treated as part of the purchase price, the installment method becomes available. This approach defers taxable gains until payments are received, spreading the tax burden over multiple years. This can ease cash flow challenges and might even help keep the seller in a lower tax bracket.

Tax Implications for Buyers: Compensation Treatment

Buyers often lean toward compensation treatment for earnouts because it allows for immediate tax deductions.

Immediate Tax Deductions

When an earnout is classified as compensation, buyers can deduct the payment as an ordinary business expense in the year it’s made. On the other hand, if the earnout is treated as part of the purchase price, the payment must be capitalized and amortized over 15 years under IRC Section 197 ^[3].

"The buyer would likely prefer for the earn-out to be treated as compensation because the company will get a compensation deduction while no deduction is available for payment of purchase price." - Leo Berwick ^[5]

Here’s an example: Imagine a $500,000 earnout payment. If treated as compensation, the buyer can deduct the full $500,000 in the year it’s paid, immediately reducing taxable income. But if the same payment is allocated to goodwill as part of the purchase price, the buyer can only deduct about $33,333 annually over 15 years. That immediate deduction can significantly improve cash flow.

"An earnout that's treated as compensation is immediately deductible. On the other hand, the earnout must be capitalized and amortized over time if it's considered a deferred payment on the purchase price." - Ryan Ham, Partner and Director, Tax, GRF CPAs & Advisors ^[6]

That said, buyers need to ensure the total compensation, including the earnout, is reasonable for the services provided. The IRS closely monitors excessive compensation arrangements ^[3]. While the immediate deduction is attractive, it does come with additional administrative responsibilities.

Payroll Tax Withholding Requirements

Classifying earnouts as compensation also brings payroll tax obligations. The IRS considers these payments as wages under Section 3401(a). This means buyers are required to:

• Withhold federal income tax
• Deduct the employee’s share of Social Security and Medicare taxes
• Pay the employer’s share of Social Security and Medicare taxes ^[8]

Precedents confirm that such payments are subject to employment taxes, adding another layer of compliance for buyers.

Additionally, compensation treatment could trigger rules under Section 280G (golden parachute payments) and Section 409A (deferred compensation), which may limit deductions or introduce further compliance requirements ^[5].

Buyer vs. Seller Tax Implications Compared

Let’s dive into the tax implications for buyers and sellers when it comes to earnout agreements. Sellers often favor purchase price treatment because it allows them to take advantage of lower capital gains tax rates. Buyers, however, lean toward compensation treatment since it provides an immediate tax deduction rather than requiring the payment to be capitalized and amortized over 15 years ^[3][5].

"From the seller's perspective, treating the earn-out as a part of purchase price is a better result because the seller will be taxed at the lower capital gains tax rate." - Leo Berwick ^[5]

The tax treatment also affects administrative and compliance responsibilities. For example, compensation treatment brings added payroll tax obligations, including FICA, FUTA, and withholding for both parties. On the other hand, purchase price treatment avoids these payroll taxes entirely. However, sellers opting for purchase price treatment may need to consider the 3.8% Net Investment Income Tax (NIIT), which doesn’t apply to wages ^[1][3].

Comparison Table: Purchase Price vs. Compensation

Here’s a side-by-side look at the differences in tax treatment:

To illustrate, let’s say a seller receives a $500,000 earnout. If it’s treated as compensation, the seller could face federal taxes of about $185,000 (37%), plus payroll taxes. However, if the same payment is treated as part of the purchase price, the tax burden would drop to roughly $100,000 (20% capital gains rate), with an additional potential $19,000 from the NIIT ^[3].

Up next, we’ll explore strategies to structure earnouts in ways that benefit both buyers and sellers.

How to Structure Earnouts for Purchase Price Treatment

When structuring earnout agreements, it’s important to position them as part of the purchase price rather than as compensation. To achieve this, focus on framing the earnout as a deferred payment for the business itself, avoiding any suggestion that it rewards future work.

Reducing Service Conditions

To ensure earnouts are treated as part of the purchase price, avoid tying them to employment or service conditions. Payments should not depend on whether the seller continues working for the buyer. Instead, the purchase agreement should clearly state that earnout payments will be made regardless of ongoing employment. This separation is key to demonstrating that the payment is for the business assets, not for labor.

Additionally, use separate employment or consulting contracts to provide market-rate salaries for any post-sale services. This approach clarifies that the earnout is unrelated to compensation for work performed after the sale.

Another tactic is to link earnout payments to objective business metrics, such as EBITDA or revenue targets, rather than individual performance. This reinforces that the payment reflects the value of the business rather than rewarding personal contributions.

Setting Payment Levels Above Reasonable Compensation

Earnout payments should reflect the business's value rather than employee earnings. To achieve this, establish a market-rate salary for ongoing roles and document that the earnout was designed to bridge a valuation gap during negotiations. This distinction helps solidify the earnout as part of the purchase price.

"The best way to resolve this dilemma is to agree to pay amounts (whether wages, bonuses or fees for consulting services) to former owners continuing with the business that constitute reasonable compensation for tax purposes, as well as to structure earnout payments in line with the valuation of comparable businesses."

• Julie M. Bradlow, Partner, DarrowEverett LLP ^[2]

Distributing Payments Among Multiple Sellers

To further support the classification of the earnout as a purchase price, distribute payments proportionally to all shareholders based on their equity ownership. If earnout payments are limited to active sellers, it could signal compensation rather than a return on capital. Instead, include all shareholders - whether active, passive, or departing - and ensure payments are strictly tied to ownership percentages.

"If there is proportionality - all sellers receive the earnout based on the services provided by a minority set of owners - this indicates a return on capital and deferred purchase price."

• Mary Van Leuven, Director, Washington National Tax, KPMG LLP ^[4]

This principle is clearly illustrated by two cases: Lane Processing Trust v. U.S. and R.J. Reynolds. In Lane Processing Trust, payments were ruled as wages because eligibility depended on employment status, and amounts were tied to job roles and service length. In contrast, the R.J. Reynolds case ruled payments as equity-related since they were distributed strictly based on ownership percentages, reinforcing their classification as a return on capital.

Conclusion

How earnout payments are classified - either as deferred purchase price or service compensation - has a direct impact on tax implications. Sellers face a tax rate of up to 20% on capital gains, compared to 37% on ordinary income, which may also include employment taxes. For buyers, the classification determines whether they can deduct payments immediately (under compensation treatment) or must amortize them over 15 years as part of the purchase price ^[3][7].

The IRS uses a "facts and circumstances" test to decide how to characterize these payments. Key factors include whether the payments are tied to continued employment, if they align with equity ownership, and whether sellers are compensated fairly for any services provided after the sale ^[5][1].

"The best time to ensure that the parties' intention may easily be inferred from their facts and circumstances is before concluding the transaction." - Louis Vlahos, Partner at TaxSlaw ^[3]

To avoid complications, earnouts should be clearly structured from the beginning. For instance, separating earnouts from employment-related payments and establishing market-rate salaries for post-sale services can help demonstrate that these payments are tied to the business's value rather than being disguised compensation. Structuring earnouts proportionally to each seller's equity interest further supports this distinction.

Proper planning is essential to secure favorable tax outcomes. Given the complexities involved and the IRS's close scrutiny, working with experienced tax professionals is critical. Phoenix Strategy Group offers M&A advisory services and fractional CFO support to assist growth-stage companies with earnout structuring, tax planning, and exit preparation. Their guidance ensures that both buyers and sellers can achieve their tax objectives while staying compliant with IRS regulations.

Early planning and thorough documentation are key to minimizing tax liabilities and aligning the interests of all parties involved.

FAQs

What makes an earnout taxable as wages instead of capital gains?

When an earnout is classified as payment for services the seller provides after the sale, it is taxed as wages rather than capital gains. This usually happens if the seller remains employed by the company after the transaction, as the payment is viewed as compensation for their ongoing work.

How can we structure an earnout to avoid being tied to employment?

To avoid linking an earnout to employment, structure payments around business performance metrics like financial or operational targets. Specify in the agreement that the earnout depends solely on meeting these objectives, not on the seller's employment status. This distinction ensures clarity and fairness in the arrangement.

What documents support the intended tax treatment of an earnout?

Key documents should clearly outline payment terms, the deal structure, and whether the earnout is categorized as part of the purchase price or as compensation. Additionally, supporting agreements and IRS guidance play a crucial role in ensuring the correct tax treatment is applied.

Related Blog Posts

• Capital Gains vs. Ordinary Income: Earnout Tax Guide
• Tax Rules for Earnouts in M&A Deals
• Earnout Payments: Tax as Compensation vs. Capital Gains
• Earnout Payments: Tax as Compensation or Purchase Price?