When Are Earnouts Treated as Compensation? A Seller’s Perspective in Professional Service Firm Deals
Accounting firm M&A deals often involve complex tax issues, and it’s important to understand their implications before undergoing negotiations and diligence so that you aren’t caught off-guard or have unwanted consequences. If you have any questions on this article, please do not hesitate to reach out to the author or Russell Shapiro, who leads LP’s Accounting Firm Practice.
As part of our ongoing series on tax issues for accounting firms, this article provides information on earnouts and whether the amounts are treated as compensation from a seller’s perspective.
The tax treatment of post-closing contingent payments, sometimes called “earnouts,” is an issue that often arises in acquisitive transactions. This is particularly common in professional service firm acquisitions where selling stakeholders often continue to work for the buyer after the sale closes. Earnouts require the buyer to pay the sellers additional consideration if the company/buyer achieves specified goals or meets other financial milestones by an agreed-upon future date. Earnouts are often used to bridge the gap between the buyer and seller to hedge risk and potentially obtain a higher purchase price for the seller with less upfront risk to the buyer.
Depending on the specific situation, from a tax perspective, the earnout amounts could be characterized as either (i) deferred purchase price (generally taxed at capital gains rates and subject to installment method treatment) or (ii) compensation for services (subject to ordinary income tax rates). Since buyers and sellers often have different preferences on the tax characterization of earnouts, parties should negotiate and consider the tax treatment of such payments early in the planning process.
Generally, an earnout is treated as deferred purchase price for tax purposes when the seller receives it; however, if the selling owner will continue to provide services to the company, and the earnout is contingent upon the selling owner being employed at the time the earnout is payable, it is possible the IRS could consider it to be compensation for services rendered to the buyer. While earnouts tied to continued employment are not automatically considered compensation, there is case law precedent for the IRS to scrutinize whether contingent payments should be taxed as compensation rather than deferred purchase price, as the seller prefers.
For instance, in Lane Processing Trust v. United States,[1] the court held that payments made to employee-owners were considered compensation because the payments were tied to employment and the amounts paid were based on each employee’s job classification and length of employment, among other factors. Similarly, in Estate of Morris v. Comm’r,[2] the court held that payments to the sole shareholder of an acquired corporation for consultation services most resembled compensation and should be treated as such, even though the payments enabled the buyer to retain a valuable customer list.
Conversely, in R.J. Reynolds Tobacco Company v. United States[3], the company made payments to employee-shareholders based on a profit distribution plan where the payments were proportionate to the employee-shareholders’ ownership percentages in the company. The court held that the payments were not taxable as compensation because: (i) they were proportionate to equity ownership, (ii) the payments would be considered “unreasonable” if treated as compensation because the employees already earned market-rate salaries, and (iii) the company’s long-standing treatment of the payments as related to ownership was approved by its advisors in accordance with best practices.
Accordingly, tax advisors’ analysis regarding whether earnouts should be classified as compensation or deferred purchase price is fact-specific and guided by the following general principles as distilled from case law:
- All else equal, if the earnout is commensurate with typical employment compensation for that role, the payments are more likely to represent employment compensation upon IRS examination. Where, however, the amount of the earnout far exceeds typical and reasonable employment compensation, it may be properly characterized as deferred purchase price.
- As discussed above, where receipt of the earnout is contingent upon being employed when the earnout is paid, generally that amount is also more likely to represent compensation upon IRS examination.
- Where the earnout for all owner-employees is only contingent on a threshold level of employment of a few key owner-employees on the date the earnout is paid, the argument for purchase price characterization is stronger. In other words, if the buyer purchased a bulk intangible “workforce asset” not directly correlated to the services provided by any one individual, the earnout is more likely to be deemed a deferred purchase price. In assessing the characterization, additional factors include the total number of owners, the number of owner-employees who remain employed by the company post-acquisition, and whose services are specifically tied to the earnout. The more lopsided, the better the argument for purchase price. The analysis here is inherently fact-specific.
- Where the total potential earnout is reduced in a corresponding manner for each terminated owner-employee, and that potential payout is retained by the buyer, it may imply the payments are compensatory in nature since there is a direct correlation between earnout amounts and percentage of owner-employee retention.
- Conversely, if the amount previously due to the terminated owner-employee is instead reallocated to the non-terminated employees, and the total fixed potential earnout does not decrease, that implies the payments are deferred purchase price.
Acquisition Planning Considerations
In applying the principles above, there are a few planning considerations that parties to an acquisition should consider if they want more definitive treatment. The following are some options:
- Using covenants not to compete. Instead of an earnout contingent on continued employment, which puts the payments at risk of being classified as compensation by the IRS, a buyer could, and customarily does, use a “covenant not to compete” to ensure the owner-employees remain with the company for the protection of the buyer. If structured properly and the owner-employee had not historically entered into such an agreement with his seller firm, earnout payments may be characterized as capital gain if they relate back to the sale of an owner-employee’s personal goodwill, as evidenced by entering a new non-compete with the buyer and in essence “selling” their personal goodwill to the buyer in a separate transaction. (Note: We’ll explain more aboutnon-competes and personal goodwill in a subsequent article in this series.
- Incorporating stipulations in the purchase agreement. The purchase agreement could expressly stipulate that the earnout is compensation for services and the payments can be structured to resemble employment compensation. To offset the advantage to the buyer via an immediate deduction and the disadvantage to the owner-employees of ordinary income treatment for the payments, the parties could agree that the buyer will pay a gross-up amount to the owner-employees. The gross-up would equal all or a portion of the tax differential to the owner-employees between ordinary income and capital gains, essentially making the owner-employees whole for the disparate tax treatment.
- Using restricted equity as part of the purchase price. Though it changes the economics of a deal, parties may use restricted equity as part of the purchase price consideration as opposed to earnouts subject to continued employment. The equity could be subject to forfeiture based on participation thresholds and time-based vesting, which can accomplish similar goals the parties may have on incentivizing performance and retention of key employees. Although the equity granted would be treated as compensation income under Code Section 83, the ordinary income amount may be minimized by recognizing for tax purposes the value at grant rather than the future value at vesting through use of a Code Section 83(b) election. The Code Section 83(b) election applies tax at the time of grant instead of upon the subsequent lapse of the restriction, after which the owner-employees should generally receive capital gain treatment on a subsequent sale of the equity.
When representing the owner-employee, who will usually prefer capital gain treatment on earnouts, consider whether the purchase agreement should:
- Be drafted to maximize support for the tax treatment of purchase price payments and clarify the parties’ agreed-upon intent that the contingent payments are (i) to protect the buyer’s investment in the business, (ii) act as a risk reduction hedge of total purchase price consideration payable at close, and (iii) are not intended to be compensatory in nature but rather an adjustment to final purchase price.
- Explicitly include language stating that the buyer is not paying separate consideration for future employment and that the earnout payments are part of the overall purchase consideration paid for the business. This language can support the claim that the earnout is not a separately bargained-for compensatory arrangement but, instead, is inseparable from the purchase price.
- Include a specific business value attributed to the contingent payments since an agreement by the parties on the value of the business represented by the earnout payments may help defend their treatment as part of the purchase price and feels less like compensation when stipulated in this manner.
Sellers should pay close attention to the tax treatment of post-closing contingent payments and, to the extent possible, should comport transaction documents to maximize the substance of the tax treatment. LP corporate and tax attorneys can provide recommendations on how to structure the contingent payments to achieve the optimal tax position for the sellers.
[1] 25 F.3d 662 (8th Cir. 1994).
[2] 46 T.C.M. 993 (1983).
[3] 149 F. Supp. 889 (Ct. Cl. 1957).