Taxation of Earn Out Payments

April 27, 2012
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A seller of a business should consider the impact that a contingent sales price will have upon the amount to be realized net of tax.  A contingent sales price is adjusted by reference to performance milestones and is taxed as an installment sale.  The adjustments may be positive or negative, depending upon whether there is a maximum or minimum sales price, not to mention the other milestones that cause adjustments.  What is often missed is the impact that these variations have upon the timing and recognition of income. Negotiations over the sales price of a business are often difficult, because there is always risk that the enterprise will not perform after the sale as it has in the past.   In the context of a typical, closely-held business, the proceeds of sale represent a significant portion of the owner’s retirement fund and the owner does not want to sell too cheaply. The buyer, on the other hand, is concerned that the best days of the target business are behind it, and that he or she is overpaying.  A contingent sales price is one means of bridging the gap in price between the positions of buyer and seller. There are three categories of contingent payments. The first is where a maximum sales price is determinable.  The second is where the maximum selling price is not determinable, but the period over which payments will be received is fixed. The last category is where there is neither a maximum price nor a definite term.  The buyer may then negotiate a cap on the earn-out while the seller may want a make-up provision that would permit the unused cap to carry forward to subsequent years. What is sometimes overlooked in negotiations is that the seller’s basis (or tax cost) is recovered differently in each of these scenarios, because the profit percentage that is applied to each payment is different for each method.  Although a seller may want a large cap or upside, an unattainable figure will cause more harm. A large unrealistic cap will require that the seller recognize more income in the earlier years and will result in a capital loss at the end of the term.  This is because the profit percentage is overstated. A seller should be aware of how basis is recovered under each proposal that is presented.  It is to the seller’s benefit to recover more basis in the earlier years of the payout period because this results in reporting less income.  Where the cap is exceedingly high and unrealistic, a taxpayer may be forced to apply for a private letter ruling to obtain relief from these distortions that occur when the profit percentage is overstated.