What Earnouts Mean for Your Books and Taxes

Getting the buyer and seller to agree on the purchase price is one of the numerous difficulties in any business negotiation. This is especially valid throughout

Current business results might not accurately represent the target’s past or future earnings during periods of economic volatility like the COVID-19 pandemic. The parties may decide to add an “earnout” in the acquisition agreement to help them determine a fair purchase price that takes this ambiguity into account.

The book and tax treatment of earnouts rely on documentation, so buyers should talk to their attorneys and tax consultants at a CPA firm in Aventura, FL, about how they want to treat the earnouts. These talks should consider the essential criteria used to determine whether an earnout is pay or purchase consideration. Buyers can better position themselves to prevent unexpected book and tax treatment by outlining the goal and ensuring the paperwork reflects the desired outcomes.

The concept of an earnout

An earnout, in general, is extra money given to the seller of a business if it meets particular sales or EBITDA (profits before interest, taxes, depreciation, and amortization) goals after the acquisition. The earnout is viewed as additional consideration for the business and, as a result, for bookkeeping and tax purposes if it is paid. To be eligible for the earnout, however, the buyer may occasionally be asked to continue working for the company. Earnout payments linked to continued employment may be considered compensation for both book and tax reasons depending on how the purchase agreement is set up, which would lower profits.

The tax consequences of situations where a seller has to continue working for the company to qualify for an earnout can vary widely depending on which party is involved. Under the golden parachute and nonqualified deferred compensation rules, the buyer can deduct the compensation or earnout payment if it is treated as compensation and not as part of the purchase price. In contrast to the 20% cap on capital gains, non-capital gains taxes can be imposed upon the seller of the property at tax rates of up to 37%, which is unfavorable to the seller because it causes greater tax exposure.

When are earnouts considered compensation?

Earnouts associated with continuous employment are not necessarily considered compensation by the IRS; auditors may need to review the facts and circumstances to determine whether they should be taxed as compensation.